Friday, March 23, 2007

Computing the Total Return Index

Yoyo the green rabbit can help cheer me up this morning :) I get upset when I make stupid trading mistakes, primarily because I see my goal of making a living from trading recede a little bit. After a successful period I'm thinking: "I can do this". And then after a big stupid loss (caused by trading against the model rules) I think: "Maybe I'm not smart enough to do this".... oh well, onto the next step in measuring investment performance.

This step is computing a total return index, or in Australian, an "accumulation index".

Yoyo has computed her monthly returns for three months now:

December 2006: 2.71%
January 2007: 2.28%
February 2007: 2.38%

(Actually those are my returns). The first step in computing the total return index is to choose a base period. Here it is the end of November 2006. We'll give that point in time an arbitrary value, say 1000, though we could choose 100 or any other number, it doesn't make a difference.

Now to compute the value of the index at the end of December we do this calculation:

Index(Dec06) = 1000*(1+0.0271) = 1027.1

And in a general formula:

Index(t) = Index(t-1)*(1+ROR(t))

Make sure that you use 0.0271 as the rate of return and not 2.71! Just divide any percent rate of return by 100 to get the rate of return not in percent. Then:

Index(Jan07) = 1027.1*(1+0.0228) = 1050.52
Index(Feb07) = 1050.52*(1+0.0238) = 1075.52

It's easy to set this up in an Excel spreadsheet. Next up, computing annual and annualized performance.


Canadian Money said...

"...after a big stupid loss (caused by trading against the model rules) I think: "Maybe I'm not smart enough to do this"."

Been there...done that. I can relate to the feeling.

In my personal experience, I think one of the pit falls of trading, is that after we have made some profits we may not put the same value on these funds. Its easy to lose it all and more on higher risk trades.

Is this just greed at work?

mOOm said...

It's called the endowment effect or something in behavioral economics. You are more likely to be very careful with making sure you don't lose your initial stake but take bigger risks with profits. I think the longer you are at a given level of wealth the more reluctant you are to risk it.