Simply put: Financial planning has to meet long-term goals

Investment performance can be stated in several different ways. This can make it misleading and confusing to evaluate the quality of your investment strategy and the individual investments within it.

Your personal internal rate of return, time-weighted return and cost-basis return could all show different performance than the standardized performance published for a mutual fund, exchange-traded fund or other investment over a given period.

While evaluating performance is important, your most significant consideration should be given to monitoring the probability that your financial plan will fund your long-term goals. It’s this number that is the most relevant measure of your progress and the adequacy of your investments.

When measuring the performance of a portfolio with many different investments, there are two common ways to report returns.

Internal rate of return adjusts for the size and timing of cash-flow events (contributions or withdrawals from the portfolio). Internal rate of return is best used as a measure of progress against a goal — for instance, evaluating whether your long-term financial plan is on track.

Time-weighted return does not adjust for the size or timing of cash-flow events within the period being measured. It is more commonly applicable when comparing your portfolio return to a benchmark.

If there are no contributions or withdrawals, the internal rate of return and time-weighted return should be the same. The larger the amount of money moving in or out of the portfolio and the shorter the history of the portfolio being measured, the more likely to be a discrepancy between time-weighted and internal rate of return.

While these forms of returns are how professionals measure portfoliowide performance, individual investors often focus on a different measure, cost-basis return of individual holdings. Cost basis receives more attention this time of year because of its relationship to capital gains taxes in nonretirement accounts.

Many investment account statements identify the month-end market value of a position as well as the cost basis. The basis is the total amount you have invested in the holding over time adding together the initial contribution, any subsequent contributions or withdrawals and any reinvestment of income paid out by the fund.

With stocks or stock mutual funds, where more return is typically generated from changes in the price of the investment, cost basis is less misleading. With bond funds, however, cost-basis returns need extra scrutiny for many people to understand whether they have a winning or losing investment.

With funds that pay out regular income, one measure of fund performance could show gains while, in actuality, you’ve invested more in the fund than it is currently worth, signifying a loss in terms of cost basis.

Here’s a simplified example of how a fund company could report positive performance while you have a capital loss (higher cost basis than current market value).

Imagine you invest $10,000 on the first day of year. You buy 1,000 shares at $10 each. The fund pays out income of $50 per month. That income is reinvested in five new shares each month, all purchased at $10. At the end of the year, you have 1,060 shares at $10 each for a total market value of $10,600.

The price return/capital appreciation of the fund for the year was zero. The share price started at $10 and ended at $10. The total return (price change plus income paid out) was 6 percent (you earned $600 on a $10,000 investment), in this case, a relatively good return made up entirely of income paid out by the fund. Given this math, it’s possible for the price of the investment to go down but still have a positive total return. Imagine that the fund’s value dropped to $9.90 per share at the end of the year. The 1,060 shares would be worth $10,494 but your cost basis would be $10,600. It would appear that you’ve lost money but the total return would be 4.94 percent (6 percent income return reduced by the 1 percent price decline).

This cost basis return measurement then is complicated by adding the effect of taxes in nonretirement accounts. The $600 of income received was fully reinvested but you are responsible for paying tax on this income. You pay this tax due as part of your income tax filing, effectively lowering the after-tax return of the investment. This is one reason why it’s usually preferable to hold bond funds in a tax-deferred account like an IRA instead of in a taxable account.

This is also an example of how income is nice to have in a portfolio but ultimately the total return of capital appreciation plus income is more important. And total return is certainly the appropriate figure to use when measuring performance and progress toward your goals.

Gary Brooks is a certified financial planner and the president of BHJ Wealth Advisors, a registered investment adviser in Gig Harbor. Reach him at gary@bhjadvisors.com.

This story was originally published March 4, 2017 at 10:52 AM with the headline "Simply put: Financial planning has to meet long-term goals."