How do you know when your investments are performing well? The question is more complicated than it sounds. It is also an important one because making the right investment choices can mean the difference between achieving your financial goals and falling short.
Find the Right Benchmarks
The traditional way to measure investment performance is to compare results with an appropriately matched index. Assuming your portfolio and the index share similar characteristics, this method can provide you with valuable information about your investments’ performance.
If your portfolio outperforms this index — particularly over the long term — you generally can feel confident in your investment selections. However, if your portfolio regularly underperforms the index, it is time to investigate. One common reason investments such as mutual funds lag their benchmark indexes is because of the expenses associated with managing these funds. So, before you assume you own a dud, compare your fund’s expense ratio to the performance lag.
For a single investment, it is often easy to find a suitable benchmark. In fact, the prospectus of every mutual fund lists an official benchmark. However, when you are trying to evaluate an entire portfolio diversified across multiple asset classes, such as domestic stocks, domestic bonds and foreign securities, you may need a customized benchmark composed of several indexes. By combining several indexes, you are more likely to arrive at a useful frame of reference.
Comparing your portfolio’s performance to that of an index or combination of indexes provides valuable information. However, it misses a key variable that is critical to investment evaluation: risk.
Consider two portfolios that generate the same 10% gain during a 12-month period. The first achieves that performance with highly volatile securities, while the second does so with relatively conservative investments. Most investors would agree that the second portfolio is the better performer because it achieves the same results with less risk.
This concept is referred to as risk-adjusted return. It can be quantified using a variety of sophisticated statistical tools such as standard deviation and the Sharpe ratio. Your advisor can help you apply these tools to determine your portfolio’s risk-adjusted return.
Focus on Goals
Another way to evaluate investment performance is to employ a goals-based perspective, meaning that you invest not to achieve a particular return but to realize personal objectives. In other words, you do not necessarily need your portfolio to return 8% every year for the next five years, but you do want to be able to afford college for your kids or health care costs in retirement.
With a goals-based approach, the process starts with a specific assessment of the amount of money you will need to achieve your objectives. Then, based on your current savings coupled with assumptions about such factors as future investment performance, savings rates and inflation, you can measure the progress you are making toward your goals. If you are ahead of your target, you may want to invest more conservatively to reflect your progress with the added bonus of lowering risk. And, if you are behind where you need to be, you can start saving more or invest more aggressively to generate a higher potential return (albeit with greater risk).
Goals-based investing is fairly complex because your objectives, life circumstances and savings ability are constantly changing. For this technique to be valuable, you will need to work closely with your advisor to keep your goals and financial assumptions current.
An Approach that Fits
There is no one right way to measure your portfolio’s performance. Each of these methods can be worthwhile. Your financial advisor can help you view your investments in the right context and give you the tools you need to feel confident about the future.
For more information, contact Steve Lewis. Visit ORBA.com to learn more about our Wealth Management Services.