Measuring Portfolio Performance

As each year comes to an end, it’s natural and appropriate to take a few minutes to take stock of the status and performance of your portfolio. For tax purposes, year-end is a good time to take a look any capital gains incurred in your taxable portfolios with an eye towards selling to generate capital losses that can offset some or all of those gains.

Often, the process of tax loss selling exposes companies that have some fundamental problems―the kinds of problems that can impact the long-term potential of those stocks. In these cases, selling to incur a tax loss provides a double benefit: not only is a tax benefit created, but the quality and potential total return of the portfolio is strengthened.

Another year-end task that should be undertaken is a review of the balance and diversification of your equity portfolio. Are you over- or under-weighted in certain industries or sectors? Do you own too many large-cap stocks?

While selling purely for diversification reasons is not generally a sound approach for a long-term-oriented portfolio of stocks, a review can provide a directional roadmap for future investments. For a portfolio that is over-weighted in a particular sector, future investments can be directed away from that sector and thus help bring the diversification back into line over time.

Measuring Investing Success

The end of the year is a particularly good time for determining your success in meeting the return objectives of your investments. Are you meeting your expectations? Is your portfolio beating the returns of the overall market or other appropriate benchmark?

While the concept of measuring the return of portfolio seems straightforward enough, there are some traps along the way that must be avoided.

The first trap is a reliance on the simple rate of return on an investment. Simple (or cumulative) return is the actual percentage change of an investment’s value. An asset that was purchased for $10,000 and is presently valued at $11,000 has gained 10%. Is that a good rate of return? It’s impossible to tell without knowing the length of time for which the investment was active. In addition, if there were any additional purchases or sales of the asset since it was first purchased, the simple calculation of gain would be relatively meaningless.

What is the right method to use then in calculating the returns of a portfolio? The method must take into account the timing and size of the cash and security movements into and out of the portfolio. It may or may not take into account dividends or distributions. Finally, it should present the rate of return on an annualized basis.

A calculation that computes the Internal Rate of Return (IRR) of the investments is generally considered an appropriate way within the financial industry of measuring the performance of a portfolio. Then, results are calculated using annual compounding, reaching a value known as the Compound Annual Return (CAR). The compound annual rate of return for an investment held for less than one year is somewhat hypothetical; the IRR is calculated as if the cash flows, size of the investment, and rate of change continued in the same manner for a full year.
 

Comparing Returns to a Benchmark

Once the CAR is calculated for an individual security or for an entire portfolio, though, do you have enough information to measure the returns of your portfolio? Probably not, since there is still one important factor missing. If the CAR of a portfolio is calculated to be 15% for the period in question, is this a good or middling or terrible rate of return?

The answer is “it depends.” That 15% return is probably considered excellent if the alternative is a 2% rate of return in a CD that could have been earned in the comparable period, or the 4% that might have been earned from Treasury bonds. If the overall stock market grew by 19% during that same period, a 15% rate of return might be unacceptable.

This is where the concept of benchmarking comes in. Benchmarking is the process of comparing the performance of a security or portfolio to a representative market index, portfolio, or security. Stock investors commonly benchmark their portfolios to a broad-based market index such as the Standard & Poor’s 500 Index or the Wilshire 5000 Total Market Index.

Another approach would be to benchmark separate portfolios or segments of a portfolio to a representative index. For instance, you could compare only the small companies in a broader-based portfolio to a small-cap stock index such as the Russell 2000.

In order to properly benchmark a portfolio, a separate series of calculations must be computed by replicating the cash flows of the original investments but using purchases and sales of the comparative index or security instead. The CAR is then calculated for that series, and the results of the actual investments and the hypothetical investments in the benchmark are compared.

If your results meet exceed the selected benchmark, then your investment strategy is working quite well. If your results are underperforming the benchmark, then perhaps some adjustment is needed to your security selection.

Of course, there is another element of returns that can be considered when evaluating the success of a portfolio, and that’s the element of risk. If a portfolio underperforms the overall market but has a lower level of risk associated with the component investments, then the “underperformance” may be completely acceptable. For this reason, a risk-adjusted return is sometimes used to capture the volatility of a particular group of investments.

Calculating the compound annual rate of return of a portfolio is not something that can be done by hand or with a spreadsheet for any but the simplest portfolios. Investment recordkeeping programs, such as ICLUBcentral’s new MyStockPortfolio.com, can easily calculate the appropriate rates of returns for a portfolio and various index benchmarks.

One final note: As is commonly disclaimed in the financial industry whenever returns are published, “past performance is not an indication of future results.” But taking the time once a year or so to take the pulse of your portfolio is a smart and sensible thing to do. If your portfolio isn’t measuring up, then taking steps to remove underperforming assets or seek out higher quality investments is a prudent action to take.