Posted by Tony Ryburn on August 6, 2008
One of our most important objectives in setting up Sharesight was to give you the true return on your shares. One of the many shortcomings of the so called ‘free’ sites is that they fail miserably in this vital area.
One of the reasons they fail is that providing you with the true, annualised return on your shares is trickier than it sounds. For a start you need to have a large amount of data at your fingertips and you need to be able to account for corporate actions like dividends, share splits, amalgamations and bonus issues because these will make nonsense of return calculations if you don’t.
To further complicate matters, there are two common arithmetically correct ways to calculate returns and in some circumstances they can give radically different answers. The two methods are the compounding method and the simple or non-compounding method.
The easiest way to appreciate the difference between the two methods is to consider a deposit account at the bank. If the bank quotes you a 7% interest rate this is a compounding rate. This means that if you do not withdraw your interest it will remain in your account and you will receive interest on that interest. Under the simple or non-compounding method, interest is calculated only on the original amount invested.
It is clear from the table below that $1000 invested for 10 years at 10% using the simple method does not equal 10% using the compound method. The simple method results in the return of your initial investment of $1000 plus a further $1000 of interest at the end of 10 years, whereas the compounding method results in the return your original investment of $1000 plus $1593.74 of interest. In fact an investment of $1000 that results in a return of that investment plus a further $1000 of interest over 10 years, equates to a compound return of approximately 7%.
|
Rate
|
| Time |
10% Compounding* |
10% Simple |
7% compounding* |
| Y0 |
1000 |
1000 |
1000 |
| y1 |
1100 |
1100 |
1072 |
| y2 |
1210 |
1200 |
1149 |
| y3 |
1331 |
1300 |
1231 |
| y4 |
1464 |
1400 |
1320 |
| y5 |
1611 |
1500 |
1414 |
| y6 |
1772 |
1600 |
1516 |
| y7 |
1949 |
1700 |
1625 |
| y8 |
2144 |
1800 |
1741 |
| y9 |
2358 |
1900 |
1866 |
| y10 |
2594 |
2000 |
2000 |
*figures have been rounded for simplicity. This example illustrates annual compounding
To compare apples with apples a compound return calculation must be applied to your share portfolio if you want to compare its returns with a bank deposit. In the example above the correct return to compare to a bank deposit is 7% compound not 10% simple.
So what does Sharesight do?
Until now Sharesight has used a simple return calculation. This method is widely used to calculate share returns. Although it is arithmetically correct, it produces figures that overstate share returns in comparison to a compound return on a bank deposit.
This is why we have introduced a compound return calculation that you can select and apply to all tables in Sharesight that display return information. We use a daily compounding formula as this is standard practice among banks. Although simple interest will remain as the default setting you can choose to switch to compounding returns on a per portfolio basis by editing the portfolio settings (found under the settings link at the top right of the screen). There is also a link to change the percentage return method at the bottom of each page for which compounding return figures are available.
So which is correct and what should you do?
Both methods are arithmetically correct. We at Sharesight do not wish to get embroiled in a debate concerning the merits of one method over the other. You are free to choose which ever method you prefer.
Some more technical information about the formulas that Sharesight uses to calculate returns can be found here.
We also answer some common questions about compounding interest (and a variety of other questions) in the frequently asked questions section of the help documentation, which can be found here.
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