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Retirement & You

By Philip Kozloff,

Previous columns have talked about strategies and philosophies for managing your wealth for a successful retirement. This column will deal with some of the practicalities of measuring your financial wealth and its changes in value.

Assessing an individual’s investment account performance is more difficult than that of an index, a fund or a unit trust. For one thing, it is complicated by the presence of in and out transactions. The methodology explained below is intended to help you isolate true investment performance from potentially distracting information resulting from additions and subtractions from an investment portfolio.

A summary report should be assembled that reflects major investment categories. Preferably, this should be on one sheet of paper for manageability. Information from your broker or financial advisor should be your best source for this information. But be sure to include those financial items that may not be managed by your financial advisor, such as unit trusts, pension plans and plain old cash.

Changes of the positions should be tracked on a regular periodic basis. Quarterly, for example, works very well. The report should have three columns: Starting Position, Additions/Subtractions, and Ending Position. A fourth column, Changes in Value (the difference in the Position that is not accounted for by Additions or Subtractions), can be added for convenience.

So far, this is a conventional approach. However, let’s look at your investment situation in a slightly different way. Instead of viewing your financial wealth progressing over time as a sort of squiggling line – let’s think of your finances as an area, rather than a line.

We’ll call it “Bi-Modal Portfolio Analysis.” It is as if you thought about you assets converted to coins, although very valuable ones, on a table top. If you arrange them in a square to start with, you can see that you can re-arrange the coins into another shape, say a rectangle, that has the same value as the square, because you used the same number of coins.

On the other hand, you can increase your horde of coins by adding another row along the top or side without disturbing the formation you started with. Conversely, you can reduce your wealth by removing a row or two, leaving you with a slightly different coin arrangement. Either way, you can compute the value by multiplying the number of coins of the width of your spread by the height.

The same applies to financial accumulation. You can see that there are only two ways to increase your personal wealth: you can add to it from outside sources (say work-related earnings) or the value of the investments may grow as a function of market forces and investment yields such as interest and dividends. Of course, the same applies to the reduction of your personal wealth: you can spend it or your investments might lose market value. Of course, combinations in any proportions of increases and decreases are possible.

Therefore, it is useful to look at the changes in your net worth as a function of two variables: whatever additions or subtractions arise from external forces (earnings, spending) and internal dynamics (changes in value).

The same can be done notionally with your financial investments. Let’s assume that you are a working investor with a decent nest egg of $1,600,000. For simplicity, we will work only with the thousands, $1,600k. We will use a square as a starting point. The square root of $1,600k is $40k, so that is the dimension for each of the sides of the square. Graphically, x=$40k and y=$40k). Let’s have the x-axis represent changes in value by virtue of internally driven changes in value (the “Value Indicator”) and the y-axis represent external additions and distributions (the “Contributions Indicator”).

If you received a nice bonus in the first financial quarter and saved $65k, the value of the Contributions Indicator would increase to $41.6k ($1,665k divided by the Value Indicator at the beginning of the quarter $40k). The value for the Contributions Indicator would increase to $40.8k (your ending net worth $1.700k divided by the Contributions Indicator $41.6k), or 2.1%.

Extended over a further hypothetical ten years, growth follows a much more erratic path, reflecting the additional information. The spacing between data points is visibly variable reflecting the differences in changes of portfolio value (either due to contributions and withdrawals or changes in value). Note that time is represented only in the sequence of data points. A larger distance between data points indicates that values changed more in that fixed period, a financial quarter of a year in this example.

This approach provides a methodology for separating investment-driven growth from savings-driven growth so that each can be evaluated on its own merits. With this information, you are able to evaluate the financial performance of your investments without the interference of “noise” from the effects of contributions to and withdrawals from your investment portfolio.

Set up your own portfolio information along these lines. In the coming months, this column will use this methodology to suggest to you how to assess your portfolio performance and guide you towards understanding when your investment portfolio is comfortably positioned to accommodate your retirement.

Profit & Loss

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