If you’ve taken the advice on this site seriously, you probably already have a rock-solid dividend portfolio. Perhaps you’ve even managed to set up a monthly income stream like we suggested a few months ago. Cash now rolls in with absolutely no effort on your part and you can sit back and watch your portfolio create wealth for you.
But how do you know if your investments are actually doing well? Sure, dividend stocks pay out a sizable chunk of earnings every year and you keep a close eye on the stock prices of individual holdings, but how do you measure your investment performance?
You might be tempted to skip this whole article since you already know the easiest way to measure investment performance – total return. You simply add the dividend yield from the portfolio to the capital appreciation of all the stocks within the portfolio to arrive at a single percentage number that encapsulates your performance. However, total return doesn’t give you the full picture.
Isn’t Total Return Enough?
Not exactly. While total return is easy to measure and an incredibly useful measure of how much money you’ve made, it may not tell you everything you need to know about the way you’re investing.
The average portfolio tends to expand and contract over time as you withdraw money or invest more from other sources of income. If you invest $1,000 at the start of the year, another $1,000 at near the end of the year, and the value of your portfolio is $2,200 at the end of the year, is it fair to say your return was only 10%? Similarly, if you start the year with $1,000, take $500 out mid-year, and end the year with $1,000, is your return 0%?
Confidently picking stocks and maintaining a portfolio for the long-term involves digging deeper into your performance and comparing it to the rest of the market. You needs to ensure you’re pushing your money as hard as you can and actually getting decent returns for all the time and effort you apply to investing.
Trouble is, there’s no universally accepted way to measure performance. So, here are some of the methods professionals use to make sense of their activities every year.
Kicking things off with the most basic performance metric, Holding Period Return is probably the easiest method on this list.
To calculate it, you need to decide the appropriate time frame. You can compare returns on a monthly, daily, or annual basis. Once you’ve made your decision, take the ending value of the asset, add the cash flows, and divide by the initial amount. Here’s the formula:
Holding Period Return =
Income + (End of Period Value – Initial Value) / Initial Value
That’s your measure for a basic return. Remember to add the dividends you receive over the period into the denominator.
Adjusted For Cash flows
A more sophisticated way to measure performance is to keep track of the cash inflows and outflows over a period. Professionals tend to call this the cash-weighted or modified Dietz method.
Here’s what the formula looks like
The Dietz method takes account of all the cash coming into and going out of the account, leaving you with an internal rate of return or IRR that signifies your true performance. You’ll most likely have to use a financial calculator, spreadsheet, or online app to get this result.
As an example, assume you start the year with $1,000. You’ve constructed a portfolio and decided to invest another $1,000 every month for the rest of the year. By the end of the year, you have nearly $14,668.
At this stage, you can calculate your basic return. $12,000 invested and $14,668 ending balance, which means the basic return is 14,668/12,000 = 22.23%.
However, with a Modified Dietz calculator you can pin down the internal rate of return was actually a little more impressive at 25.56%. Remember that an extremely volatile portfolio will have an odd result on the ModDietz calculator.
Finally, the most important aspect of measuring your investment performance is making sure you didn’t waste your time by actively investing in dividend stocks. If you invest over the course of a year and find that your return was less than the yield on a Treasury bond, you would have been better off just buying the bond and doing nothing.
Similarly, if your investment return is less than the return on a well-known index, like the S&P 500, you could have simply bought an index fund and passively enjoyed better returns.
This is why it’s important to benchmark your performance. Start by selecting the most appropriate index, based on the style, size, and sectors included in your portfolio. If you invest exclusively in dividend paying stocks, try to benchmark against the Dividend Aristocrats Index. For most investors, the S&P 500 index is the best benchmark.
Compare your returns to the index returns and make adjustments to your strategy if you notice a persistent lag.
Adopting the long-term dividend stock investing strategies we keep advocating here requires a lot of patience and some careful measurements. You need to be able to confidently say your portfolio is doing well. It needs to outperform the benchmark index you pick and return a sizable average return every year.
Any one of the methods we’ve outlined in this article will help you measure investment performance. You can build the spreadsheet based on these formulas. Or find an online calculator that does all the grunt work for you. Try the one on BankRate.