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AS THE OLD SAYING goes, there are lies, damned lies and statistics. And then there’s investment performance, which may deserve a category all its own.
This topic came to mind recently when I saw a press release heralding the accomplishments of a retired nonprofit executive. Among the claims: that he had doubled the organization’s endowment. This struck me as impressive—until I considered it more critically. What did it mean that he had doubled the endowment? Did it mean that he was a brilliant fundraiser? Was it the endowment manager who was brilliant? Did the executive’s tenure coincide with a bull market that would have doubled any endowment? In isolation, I realized, it was impossible to judge.
As individual investors, we are bombarded with claims about investment performance—and it can be hard to make sense of it all. To help you navigate the numbers, here’s a five-step guide to interpreting investment performance.
Step 1: Understand the sources of growth
The first step is to grasp the basic math of an investment account. It looks like this:
Though this won’t show up on your statement, you should also subtract the taxes generated by your investments. That’ll give you the most realistic picture of your results.
Step 2: Isolate your investment returns
Intuitively, the above formula makes sense, but it’s easy to be misled. Suppose your portfolio grew from $100,000 to $120,000 over the course of a year. On the surface, it isn’t obvious how much of that came from investment growth and how much came from your own contributions.
Of course, if you didn’t contribute anything to your account during the year, the math would be easy. You could conclude that your investments grew 20%—a great result. But suppose you made a number of additional contributions. Now it’s much more difficult to know whether or not to be happy with that $20,000 increase.
Because of that difficulty, the investment industry has developed a convention called “time-weighted returns” to measure performance. When a mutual fund advertises its performance, it’ll often show time-weighted returns over, say, one, three and five years.
By looking at time-weighted returns, the idea is to isolate your investment returns from the distortions caused by contributions and withdrawals, allowing you to measure your true investment performance. Whether you’re grading your own investments or evaluating a prospective investment, always look for time-weighted returns. That will allow you to make apples-to-apples comparisons.
Step 3: Put your returns in context
Once you’ve isolated your investment returns, the next step is to compare them to a relevant benchmark, such as the S&P 500 index for stocks or the Bloomberg Barclays Aggregate index for bonds. There’s nothing magical about these, or any other, benchmarks. What’s important, though, is that they provide you with a yardstick for comparison.
How should you use these yardsticks? The most important thing is to make sure you’re looking at the right benchmark. If you have a portfolio composed of domestic, large-company stocks—like Microsoft, Apple and Amazon—the S&P 500 might be the right benchmark. But if you hold small-company stocks or international stocks, or if you own a mix of stocks and bonds, then you’ll want to look at other benchmarks and probably more than one. If you’ll forgive the analogy, you can compare apples to apples, but you can’t compare an apple to an entire fruit basket. It’s best to compare each asset class to an appropriate benchmark.
If you’re evaluating a mutual fund, you want to be especially careful. The mutual fund operator will provide a benchmark, but I’ve found it’s useful to take the recommended benchmark with a grain of salt. Stand next to a tortoise, and you’ll look fast. Stand next to sprinter Usain Bolt, and the comparison will be less favorable. Fund companies sometimes like to choose the tortoise.
Step 4: Don’t forget about taxes
This is perhaps the hardest part about evaluating investment performance, but no less important. Every investment, and every investment manager, will generate some amount of tax liability—unless the investment is held in a tax-free account. Unfortunately, you won’t know this until after the fact—when your tax return is completed. Since we’re coming up on April 15, this is a good time of year to review your portfolio’s tax efficiency. Open your tax return, looking especially at Form 8949, to see if any of your holdings are generating disproportionately large tax bills.
Step 5: Take a step back
A colleague once asked, “What in the world does the S&P 500 have to do with my financial plan?” It was a good question. As important as it is to evaluate your investments quantitatively, you should also ask these more fundamental questions: Are my investments meeting my needs? Are they growing at a rate sufficient to help me reach my goals? Are they sufficiently stable that I can sleep at night? That, in the end, is probably the best measure of success.
Adam M. Grossman’s previous articles include Oracle of Boston, When in Doubt and Rolling the Dice. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
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“What in the world does the S&P 500 have to do with my financial plan?”
I think of the S&P 500 as the gold standard for stocks. So let’s say my risk profile nets an AA of 70/30. I want my returns to be around: 70% of the S&P 500 plus 30% of intermediate term treasuries/total bond. Granted, overseas diversification may complicate that compare, but it’s not that tough to work around, and if that diversification is why I fell short, well, I can live with that.
However, that’s just a gauge of investment efficiency – are you pulling in most of the beta that’s easily available to you. It’s impossible to use this compare to figure out if you’re on track or not.
I have about 5 different forecast type measures of whether I am on track. The basis of them all is my estimate of how much income I will need in retirement, which after puts and takes, just kept gravitating to 100% replacement, driven by more travel costs. Then, the calculation of how much you will need is fairly simple, I’ve found that backing into it with the 4% rule yields a fairly similar answer to creating an annual cash flow projection. To understand if account balances will hit the necessary totals I then look at several related measures: simple account projections, to PV funding ratio, to income ratio, to Net Worth growth trends – I even calculate % of PAW (how close I am to being a “prodigious acquirer of wealth” as described in ‘The Millionaire Next Door”).
These measures all tell similar stories, thankfully, but they also provide their own nuance, as well as describing a range of expectations which I find useful in understanding my actual status… because the truth is that there is no single answer to this exercise, it’s an exercise in probability, but incorporating the fact that future returns are not so much a probability as a supposition. Like Eisenhower supposedly said about plans, a forecast is useless, but forecasting is essential.
P.S. It’s not really hard to figure out actual returns for the year as long as you know the amount and date of your contributions. A pretty accurate shortcut is to just take starting balance, and add a percent of each contribution. Say you started with $10,000 and added $1,000 March 31st from your bonus plus $100 per month from your paychecks, and ended at $13,000. You start with the 10,000, add $750 bonus ($1000 * 9 mos/12 mos), and then add $600 (12 payment of $100 = $1200 * 6 mos avg time invested / 12 mos). That’s $11,350, which is basically the annualized amount you had invested and earning returns during the course of the year. Then divide $13,000/$11,350, (=1.145, subtract the one since you are just looking at growth, to get 0.145) and your return for the year is 14.5%. There are a couple shortcuts in this method, but it’s been accurate to one hundredth of a percent every time I compared to my statement.
Thank you for this example — it’s clear, concrete, and immediately useful.