We got a call recently from a firm that wants us to review their method to derive returns. They take their beginning market value plus cash flows to determine an average capital base; they then determine their account’s appreciation for the period and calculate a simple average to derive the return. Extremely intuitive, yes?
But sadly wrong, too. (Hopefully you agree).
This isn’t the first time we’ve encountered firms who employ a proprietary approach to derive returns. Not long ago during a conference lunch I was sitting next to an attendee who told me of the approach they had developed. Again, quite intuitive … one that surely no one would find objectionable. Unfortunately, it, too, was invalid.
Long ago, before the publishing of performance books and various standards, individuals were often compelled to figure out a return methodology on their own. Fortunately, this is no longer the case. So, if you have such a formula in your shop, perhaps you should have it checked out.