I find it amazing when I ask people this simple question, most have no idea what their long-term investment performance has been.
You would think this would be the most basic information given to any investor.
Have you made any money?
The Financial Advisers and Intermediary Services (FAIS) Act includes a General Code of Conduct which goes into reams of actions and behaviours expected of advisers. From disclosures on fees and conflicts of interest, records of advice and copious information on products and funds.
But when it comes to the above basic question, the focus is largely on reporting per product or fund. As a result, you can expect to receive a portfolio statement appended with fund fact sheets and possibly calculations of profits separately for each investments.
As I explain below, you may be given a lot of information which may lead you to believe you are doing well. It can easily be misleading.
In this article, I will show that, unless you are provided with the accurate calculation of the rate of return on your whole portfolio from inception, you will have no idea whether your performance is anywhere near to your expectation and indeed whether you are making money or not.
How Inflation impacts on the Return and Value of your Money.
Here is the thing. Money isn’t like a tank of water. As you add more water, the tank keeps filling up. The higher the level in the tank, the more water you have. You can measure it and know at any time, how many litres you have accumulated.
Money is rather like air in a tyre with a slow leak. If you pump air into the tyre, it gets harder. But when you return, some of the air has escaped, and you will need to pump in more air to keep it inflated. However, if you leave it long enough, the tyre will become competely flat.
This impact of inflation on the value of your investment is fundamental to the question of whether you are making money or not. Inflation is a continuous process which devalues your investment all the time. Even over a relatively short period of time such as 5 years, the impact of inflation on the value of your money can be quite significant.
Because inflation has a continuously slow but steady impact, its immediate impact seems negligible. However, over any meaningful period of time, the impact is usually really dramatic.
The graph below shows the devaluation of the purchasing price of the US$ over 120 years.
If you purchased something for $1 in 1900, you would need nearly $36 today to purchase the same thing. And that has been at a relatively low level of inflation of 2,95% per year.
It also doesn’t matter whether you invest in US Dollars, Euros, Pounds or Rands. They all suffer from inflation, just to different degrees.
So, in determining the value of your portfolio and asking the fundamental question of whether you have made any money, you MUST make an adjustment for inflation.
Investing Money to overcome Inflation and Costs.
The next problem is, the moment you take your money out from under the mattrass and invest it somewhere, it gets 2 more punctures. These are:
- Investment expenses and fees
- Tax
Let’s say you have R100,000 and you put the money into a bank savings account earning 6% p.a. The account has charges of R100pm and the government charges 15% tax on the interest you earn. Let’s say inflation averages at 5.6% p.a. over the next 3 years.
At the end of 3 years, you would need R117,758 in the account to buy the same things as you could 3 years previously.
Your investment would have grown to R119,101 by the end of the 3 years. However, you would have paid out R3,600 in expenses and R2,865 in tax, leaving you with R112,635.
So even though you invested your money in an account which had a return which beat inflation, you are still R5,122 poorer than you were at the beginning of the 3 years.
In other words, you lost money.
Imagine how devastating this strategy would be if this investment was over 25 years?
Ensuring your Portfolio is making Money.
Anyone who has sailed or paddled against a current knows how hard that can be. You’ve just got to keep paddling because if you dare to stop, you will go backwards.
Investing money is the same as this. Because of the negative impact of inflation, investment costs and tax, you must keep paddling hard to prevent yourself from going backwards.
There is nothing you can do about inflation. It is sometimes strong and other times light. Like the wind, it comes and goes, but it is almost always there. The problem in the investment world it is always against you!
On the other hand, you can have some influence on investment costs and tax by careful financial planning. However, you should be warned that the impact of investment costs can be as destructive as inflation. By signing an investment mandate with an adviser, it is common for you to agree to ongoing costs of 3% per year or even more. Regardless of the investment environment, these costs together with inflation will act as a strong additive force against you.
Assuming inflation of 5% p.a. and investment costs of 2.5% p.a., your challenge then is to build an investment solution to overcome a constant negative counter-flow of 7.5% p.a. to just break even. This is no mean feat!
To counter these negative flows, your forward thrust depends on investment returns. These come in the form of interest, rent, dividends and capital growth. You can also help a lot by adding in more money or savings.
The next challenge then is to construct a robust investment portfolio. Again, just like the canoeist, it is better to have constant forward motion rather than bursts of energy and then nothing. The latter approach often results in you going backwards and having to make up lost ground. The best approach to achieving constant forward motion is by building a widely diversified portfolio.
Beware of the Tricks to Disguise (Poor) Returns
Beware that many financial institutions and advisers will often only quote your nominal returns (ignoring inflation), making it appear you are doing well. This, or they choose a favourable period which also makes it appear you are doing well.
Consider a simplistic portfolio of shares below:
From the information provided, the portfolio has doubled in value. Not bad!
Now, consider the impact of the missing information, namely the date each share was purchased, and the impact of inflation on the quoted returns.
By including the period of the investment for each share as well as the corresponding CPI Index on those dates, the nominal growth of R225,000 turns into a real growth (in excess of inflation) of only R8,989.
Now, let’s turn to the biggest trick of all! This is how to make a bad investment appear like a good one. The vital information missing from the above table is “Share C” which was also bought on 01-01-03, but because it was a disaster, it was sold on 01-01-17 for R125,000 or at a loss and replaced by share B on the same date. Because it was sold, it no longer appears on the report. The bad performance has effectively been erased from the calculations.
To accurately calculate its impact on the portfolio return, this investment must be included, even though it no longer exists.
With this extra information, the nominal growth of the portfolio is reduced from the R225,000 as shown in the previous table to R200,000. But the REAL return is now R-238,946 after taking the impact of inflation on the whole portfolio into account.
So, depending on the type of report received by this investor, they may believe they are either doing very well, breaking even, or losing significant money in real terms!
In this example, I have used a simplistic example of how returns are typically reported for a share portfolio. However, the same dynamic occurs if the investor has a unit trust portfolio, or a portfolio of retirement funds, or more usually, a combination of various investment types.
Building an accurate Performance Evaluation System
As described above, it is really easy for your financial adviser to give you a performance report which looks good when it is not! They may hand you fund fact sheets showing glowing returns or product performance reports giving returns on each particular product. But you will have no idea of the performance of your whole portfolio measured from the starting point, and whether you have actually made any money.
It is therefore important that you insist on a simple but accurate performance evaluation system.
Let’s look at another example. In this case, the portfolio had a starting value of R100,000 on 1/1/2018. Each year thereafter, an additional investment of R25,000 was made. R15,000 was withdrawn on 1/7/2020.
The value after 5 years on 31/12/2022 was R280,000.
Based on the information provided in the table, including the CPI values on the date of each transaction, the performance of the portfolio can be illustrated as follows:
The only complexity in the above report is in the calculation of the annualized rate of return on your portfolio which is usually abbreviated to IRR (Internal Rate of Return).
IRR can be defined as the constant rate of return of your portfolio since inception, taking all inflows and withdrawals into account.
From the table above, you will know immediately that the portfolio value exceeds the CPI value of the portfolio. However, the real profit of R55,839 is a fairly meaningless number on its own.
But, the portfolio IRR of 11.03% p.a. compared to the IRR calculated at CPI tells you immediately that your portfolio is beating inflation by 6% p.a. This would be considered a very good return over time, and that you are making money in real terms.
Make sure you know the IRR of your Total Portfolio
There is no doubt that the IRR of your total portfolio measured from inception is the single most important number which tells you how your portfolio is doing, and whether you are making money or not. Without it would be like trying to do a health assessment without starting with your blood pressure!
IRR calculated on a policy or single product is useful but is subject to all the tools of manipulation in the attempt to make poor overall performance appear like good performance. Similarly, fund fact sheets provide important information about the performance of a fund and how it is doing against its benchmarks. But they provide at best only an indication of how your portfolio is doing. In fact, the performance advertised on the fact sheet may be 1800 different from the performance of your portfolio if your starting point doesn’t correspond to the reference point used by the fact sheet.
Unfortunately, the financial services industry knows how hard it is to construct a portfolio which exceeds inflation by a good margin over time. And they are very good at fudging the facts, knowing that the average client’s expectation is usually much greater than their reality. I often hear the comment by the industry that people generally don’t understand IRR, and it is costly and complex to calculate. Hence the reason why it is not provided in reports.
While the formula and process to calculate IRR may be complex, the result is a single number which encapsulates everything.
And it is really not that hard to calculate!
The example created above was done on a spreadsheet using actual CPI data and a fictitious portfolio. It took just a few minutes to create, allowing the computer to crunch the complex IRR formula. All qualified financial advisers should understand IRR and have various tools to do the calculation for their client’s portfolios. Simply said, there is no excuse for not providing it.
I cannot stress more the importance of calculating the IRR on your total portfolio every time you get a portfolio report and compare that to the IRR of your portfolio if it grew exactly at CPI. Without it, you really will have no idea where you are and whether you are making any money at all.
Richard Bryant
April 2023