Imagine you started your investment of say $2000 by purchasing shares of a few companies and your friend also inspired by your stock market endeavor purchased shares with an initial investment of $1875. Later on, after 6 months seeing the economy slowing down you sold your shares for $2105 and your friend also seeing signs of weakness sold his a couple of days later for $2000. Whose portfolio performed better?
To analyze the performance of a portfolio irrespective of it being that of a mutual fund, a hedge fund or your very own one, its essential to understand how to measure its performance in the first place. One of the more popular ways of doing this would be by using the concept of an NAV.
NAV stands for Net Asset Value.
By definition NAV is calculated as Current value of fund holdings/Number of fund shares.
Lets understand this by the following example.
Imagine you wanted to invest $10,000 in the stock market (say on the 1st of January) by purchasing shares in various companies. Lets call this investment as a whole as your “Personal fund”. Now lets arbitrarily say that each share of this $10,000 “personal fund” is worth $10 so the number of shares in this fund would be $10,000/$10 = 1000.
Putting this in the form of the above formula it would be,
NAV = Current value of personal fund/Number of personal fund shares.
NAV = $10,000/1000
NAV = $10.
Important points to note:
When we are talking about the value of each share in the fund being $10 we are assigning an arbitrary value to each share. We are not talking about the individual shares in the fund. You may have purchased 60 shares of company A and 20 shares of company B and so on but we are not bothered about that in calculating the NAV. The only thing we are concerned about is the total value of all the shares in the fund which in this case is $10,000.
Remember that the NAV is a conceptual value. If you would have chosen the initial number of shares in your personal fund to be 100 then the initial NAV would have been $100. ($10,000/100)
Conceptually speaking, a good way to understand NAV would be as the increase or decrease in the value of shares in the fund you are measuring over time.
NAV rises or falls as the value of the shares in the fund increases or decreases and not when money is added to or subtracted from the fund.
Now that we have calculated the intial NAV as $10, lets see how it changes as time passes.
Lets me describe what happened in the above table,
On January 1st
As we said above, you invested $10,000 and bought shares in various companies. For simplicity sake we had considered your $10,000 portfolio (consisting of shares in many companies) and gave it a fancy name – “Personal fund”.
The actual number of shares you might have bought could be 40 shares in Company A, 25 shares in Company B and so on but we are not bothered about that in calculating the NAV of your “Personal fund”.
Only for simplicity sake & to make the initial NAV a round number have I chosen the number of shares in your personal fund to be 1000.
So on January 1st, we have $10,000 with 1000 shares, each share being worth $10 (the NAV).
On April 1st
Lets see what happened till April 1st. As 4 months passed by, the total value of all the shares in your “personal fund” had risen to $11,000. However, the number of shares in your personal fund remained the same at 1000 as you didn’t add or subtract any money to or from your personal fund.
The value of each share had now risen to $11. That is 1000 shares worth $11,000.
On April 2nd
Seeing the good performance of you personal fund you decided to add more money ($550) you had with you. On the day you added that amount, each share of your personal fund was worth $11. So, theoretically you had to purchase 50 shares @ $11 to invest in your own personal fund.
The number of shares in your fund now increased to 1050 (1000 initial shares plus the 50 now added) and the value of your fund increased to 11,550. However, the NAV was not changed and remained at $11.
Why didn’t the NAV change even though we added money to the fund?
NAV is a measure of portfolio performance and not the amount of money in your portfolio. By adding or subtracting money, your portfolio performance didn’t change. In other words, you didn’t create value by adding money in your own portfolio, you merely increased the size of it.
On December 31st
The total value of all the shares in your personal fund had now risen to a cool $12,600. However the number of shares remained unchanged from 2nd April at 1050. NAV (or the value of each share) now was at $12.
So how well did your portfolio do in the span of a year?
Initially the personal fund started with an NAV of $10 and finally at an NAV of $12. So there was a 20% rise in the NAV over a year which basically means that your personal fund gave you retuns of 20% over the year which is considered quite good.
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