One of the reasons why we pay financial advisers and analysts to handle our investment accounts is because they are better able to deal with the confusing mathematics associated with the returns of an overall portfolio.
However, if we ignore the complicated statistics of correlations, related exposures, and other advanced statistical metrics, we can start to take control of our own personal investment portfolios by understanding how it is that the returns of the full collection of securities are calculated. By being aware of how it is that these weighted averages will build up the actual returns that we see in our bank accounts, we can then begin to look at how it is that taking on different amounts of risk will pay off or punish us in the future.
The first step to calculating our portfolio returns is to total up the value of all the money in our accounts. For now, let’s assume that our total portfolio value is $10,000. From there, we divide out the dollar value of each investment in the portfolio by the total amount, to find out how much of our portfolios is made up by that one investment.
If we have a portfolio of 4 investments worth $2,500 each, we therefore have an individual weighting of 25% for each security. The last step is to then multiply out the yield returns of these securities by their individual weightings, and to add them up. This will present us with the expected return of each security in the portfolio, after taking into consideration the fact that each of the different securities will be producing different amounts of returns. The table below illustrates our example: Continue reading