Monday, November 30, 2009

Calculating returns ... the wrong way

We got a call recently from a firm that wants us to review their method to derive returns. They take their beginning market value plus cash flows to determine an average capital base; they then determine their account's appreciation for the period and calculate a simple average to derive the return. Extremely intuitive, yes?

But sadly wrong, too. (Hopefully you agree).

This isn't the first time we've encountered firms who employ a proprietary approach to derive returns. Not long ago during a conference lunch I was sitting next to an attendee who told me of the approach they had developed. Again, quite intuitive ... one that surely no one would find objectionable. Unfortunately, it, too, was invalid.

Long ago, before the publishing of performance books and various standards, individuals were often compelled to figure out a return methodology on their own. Fortunately, this is no longer the case. So, if you have such a formula in your shop, perhaps you should have it checked out.

1 comment:

  1. GIPS has stated several recommended method to use when calculating a return. GIPS also states that a client could come up with their own version of a return calculation. Whatever method people plan to use, the best method includes the portfolio market values. Any method that uses an average calculation, will certainly not be consider a good method (see "Rates of Return .... come again?" comments - Just a note, I'm assoicate to this firm or work for them).


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