Why Am I Making Less
Than I Thought I Was?

Back in January [1997] I reported on how well the funds in our 401(k) did last year, but warned that because you invest money gradually over the course of the year, you don't get the full benefit of the published rate of return. To do so, you would have had to invest all your money at the beginning of the year.

If you're a suspicious type -- not a bad thing where money is concerned -- you might ask yourself, "Well, how much should I have made, then? How can I be sure that I'm getting the returns that I should be?"

Unfortunately, a real answer would require you to get some software and to enter figures not only for every time you bought or sold shares, but for every time your dividends and capital gains were reinvested to buy more shares (information you don't get on your quarterly statements anyway).

Fortunately, there's a rough-and-ready calculation you can use to check whether you're getting more or less what you should. It was described in a column in the Wall Street Journal on 2/2/96, and it should work fairly well for a 401(k) account where you're putting in equal amounts each month.

You can use this method to figure out what you earned on each individual fund or on your 401(k) account as a whole. And of course you can use it for any other investments you may have. Here's what you do:

1. Add up the amount you put in your account during the year, and subtract any money you took out.
2. Divide this number by two.
3. Add the result to the beginning value of your account. This is your adjusted beginning value.
4. Subtract the same number from your year-end value. This is your adjusted ending value.
5. Divide the new adjusted ending value by the adjusted beginning value.

"Confused?" asks the Wall Street Journal, with the perspicacity for which it is known. "Consider the following example. Say you invested $200 a month, or $2,400 over the course of the year ... The account, worth $15,368 on Jan. 1, grew to $19,627 by year-end.

"How much did you make? Start by taking half of $2,400, or $1,200, and adding this number to your beginning balance of $15,368, giving you $16,568. Next subtract the same number, $1,200, from the year-end balance of $19,627, leaving you with $18,427.

"Finally, divide $18,427 by $16,568. Result? You should end up with 1.11. To turn this number into a percentage, simply subtract 1 and multiply by 100. So in the example above, you would get about 11%."

Note: Because last year was the first year for our 401(k), and because payroll deductions for each month aren't actually invested until the following month, our end-of-year statements reflect only 11 months' worth of contributions. So if you invested the same amount each month, you should multiply your monthly contribution by 11, not 12.

The Rule of 72 Another handy investment calculation involves the Rule of 72, which tells you how long it would take to double your money at different rates of return. Just divide 72 by your rate of return to get the number of years. So if you make 6% a year, your money will double in about 12 years. At 12% a year, it doubles in 6 years. (Of course, that money will probably be worth less, due to inflation, but that's another story...)

That wasn't so bad, was it?

Once you've done this calculation you can check it against the rate of return published in Morningstar Mutual Funds. For 1996, the returns were 22.9% for the Index 500, 18.1% for Small-Cap, 14.6% for International Growth, and 15.8% for Emerging Markets. Morningstar's figures are adjusted for the fund's expense ratio but not for loads or other one-time fees. The Vanguard emerging markets fund has a transaction fee of 1.5% when you buy (recently reduced from 2%) and 1% when you sell. The small-cap fund has a transaction fee of 0.5% when you buy (recently reduced from 1%).

When I did this calculation for my own account, I got a result of 12.93% for my investment in Vanguard International Growth, compared to the Morningstar return of 14.6%. This was close enough to keep me happy. But when I did it for Emerging Markets, I got only 3.1% for my account, compared to 15.83% from Morningstar -- or 14.33% after I deducted the 1.5% transaction fee.

This was not so good. Horrifying, in fact. But taking a closer look at Morningstar, I saw that most of the gains for Emerging Markets in 1996 came in the first quarter, when the fund went up 10.14%. Because I started the year with nothing invested, and my first payroll deductions weren't invested until sometime in February, I missed out on most of that increase. In future years, as our balances increase, this effect will become less and less important.

Published in Bread and Cutter, September/October 1997.