Here's How Rate of Return Can Help You Invest Smarter

At first glance, judging an investment's past performance would seem to be a fairly simple exercise. For most stock market investments, such as individual stocks, mutual funds, and exchange-traded funds, a lot of performance information is readily available online.

However, the sheer quantity of information that's out there can make understanding it all somewhat overwhelming. And some of the terminology can be confusing.

So, let's make sure you understand a couple of key metrics and how to put them to use — whether you're evaluating the performance of an investment you already own, or you're thinking about making a new investment.

Annual return and average annual return

Two of the most fundamental ways of looking at an investment's results are how well it performed in a specific year and what its average annual return has been over multiple years.

Annual return

This is how an investment performed in one particular year. Let's use Vanguard's 2030 target-date mutual fund [VTHRX] as an example. If you go to Yahoo Finance, enter that ticker symbol in the search box, and then click on the fund's Performance tab, you can see how the fund performed each year going back to 2006. For example, in 2016, it generated a return of 7.85 percent.

Average annual return

To see an investment's average annual return over multiple years, look on the same Yahoo Finance page under Trailing Returns (%) vs. Benchmark" ("trailing" just means "looking back" — we'll get to the "benchmark" reference in a minute). You can see that VTHRX's average annual return for the past five years was 9.9 percent.

On their own, such metrics aren't very useful. However, when used together, they can provide helpful insight. For example, a 9.9 percent average annual return may seem attractive. But when you examine the past five years individually, you can see how unrealistic it is to expect that return each and every year. In 2015, the fund even suffered a loss.

When looking for meaning in performance numbers, context is king.

What's a "good" return?

To properly judge how well an investment has performed, you have to choose the right benchmark. Many investors make the mistake of comparing a specific investment or their entire portfolio to "the market."

It's fine to do that if you're investing in an S&P 500 index fund, which is designed to mirror the market. However, sticking with our previous example, VTHRX isn't designed to perform like the market.

It's designed for people who have less than 15 years until retirement. According to the basic rules of asset allocation, as you get older, the percentage of your portfolio that's invested in stocks should decrease and the portion invested in bonds should increase.

That's exactly how target-date funds, such as VTHRX, are designed. This particular fund holds a 72 percent/28 percent mix of stocks and bonds. Plus, it's diversified across U.S. and foreign stocks and bonds.

If you compared VTHRX's performance over the past five years to the S&P 500 (through the end of June), you might be disappointed. The S&P 500 has delivered an average annual return over that time period of 14.6 percent whereas VTHRX has averaged 9.9 percent.

But again, that's an apples-to-oranges comparison. A better comparison would be how VTHRX has performed against other 2030 target-date funds, and the same Yahoo Finance page referenced earlier tells you that as well.

The table showing the fund's average annual returns over various time periods also shows how its performance has compared with the "category" — in this case, the average 2030 target-date fund. As you can see, it has done a good job of outperforming its category.

Should past performance impact which investments you choose?

The prominent display of historical performance information can give the impression that it's what's most important in choosing investments. However, how an investment has performed in past years has virtually nothing to do with how it'll perform in future years.

What's more important is designing a portfolio around your optimal asset allocation — the mix of stocks and bonds that's appropriate for your investment time frame and risk tolerance. Then, if you're using a target-date fund, choose one with that asset allocation, keeping mind that funds with the same target date may be designed with very different asset allocations.

Even more importantly, use an online calculator to develop an investment plan — how much you need to have in your investment accounts by the time you retire, how much money you need to invest each month, and the average annual rate of return you need to achieve.

Such a plan would serve as the best possible benchmark because it's based on what you need to achieve in order to meet your long-term investing goal.

On its own, investment performance data isn't very helpful. But with the proper context — how an investment performed versus other similar investments, and most importantly, how your investments performed compared to the rate of return you're trying to achieve — can be very helpful indeed.

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Here's How Rate of Return Can Help You Invest Smarter

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