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Evaluating and Comparing Your Investment Portfolio’s Performance

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One of the most challenging aspects of investing is evaluating investment performance. There is a never ending cornucopia of information about the stock market and the various investment products that are available.

People spend a good deal of time comparing their investments to benchmarks such as the S&P 500, the price of gold, or the performance of other investors such as family members or co-workers and neighbors.

In addition, investors will more often than not remember a “great investment” completely outside the long-term performance of the investment. Let’s take a simple (hypothetical) example:

Let’s say that you and a neighbor start with $100,000

Total Return Your Investment Return Their Investment
Year 1 20% 120,000 40% 140,000
Year 2 -9% 109,200 -21% 110,600
Year 3 -2% 107,016 -5% 105,070

Even though your total return after three years is better, what most people will remember is that uncomfortable feeling they had when their neighbor pointed out that their investment manager pulled down a 40% return in year 1.

Some of our clients will remember Bill Miller at Legg Mason Value Trust. He was a legend because it was said that The Value Trust fund beat the S&P 500 index every year for 15 consecutive years (from 1991 through 2005).

Or Did It?

If you calculated the returns of the Value Trust fund as rolling 12 month periods (February – February, March – March, etc.) the fund did not outperform the S&P 500 on a consistent basis. Even Bill Miller admitted this “As for the so-called streak, that’s an accident of the calendar. If the year ended on different months it wouldn’t be there and at some point the mathematics will hit us. We’ve been lucky. Well, maybe it’s not 100% luck—maybe 95% luck.” However, while the legend of outperformance persisted many people piled into this fund never suspecting that they were paying Legg Mason high fees for the privilege of underperforming the S&P 500 index!

Diversification is the investor’s best friend, but there is no perfect formula.

A serious debate about the best strategies for building diversified portfolios has gone on for several decades. Different allocation strategies will produce portfolios that exhibit outperformance in some periods and underperformance in other periods. However, the stock market is both volatile and unpredictable; there is no such animal as an investment strategy that produces consistent outperformance. (If you run into someone who says that they have such a strategy we advise you to walk away.)

The $64,000 Question

The $64,000 question is: how long can an investor tolerate underperformance before they decide to give up on a strategy or advisor. Most seasoned investors can remember pulling the plug on an investment (such as a mutual) fund just before it took off for the stratosphere.

Some readers may remember the halcyon days of the Dot-Com bubble. By 2000 there were prominent articles claiming that Warren Buffett (aka Berkshire Hathaway) had lost his way –that he no longer understood the contemporary investment world. Time to catch the action on the NASDAQ….

 Berkshire Hathaway (A) NASDAQ
Yearly Return  2000 28.6% -39%
Yearly Return  2001 7.26% -21%

It’s worth noting that Berkshire Hathaway is a holding company that maintains a diversified portfolio of companies and also bonds.

How Wealth Analytics Approaches Investing

We believe that a well-diversified portfolio will produce higher returns (with lower risk) over the long run. We build the core of the portfolio out of the following elements:

      • Large-Cap US Stocks (both growth and value stocks)
      • Large-Cap International Large-Cap stocks
      • Small-Cap international Stocks
      • Alternative Investments such as REITs, Utilities, Mining Stocks, and Energy Stocks

In addition, in larger portfolios we often hold Satellite positions. These are individual stocks that may be picked by us or by our clients.

Last, but not least, we hold bonds and cash. A 60/40 portfolio would look something like this.

Individual Stocks (Satellites) 5% – 10%
Large Cap US Stocks 30%-35%
Large Cap International Stocks 10% -15%
Small Cap International Stocks 5%-10%
Alternative Assets 5%-10%
Bonds 35%
Cash 5%

Because the global stock markets are always presenting new opportunities and new risks, we use a flexible approach to allocation. Over time we may emphasize one area such as international developed markets; however we make changes allocations gradually –we are not market timers.

We also build satellite positions (individual stocks) in the hope that we can take advantage of an opportunity in a particular company.

How Wealth Analytics Evaluates Performance

Because we are financial planners first and foremost we approach investing from the perspective of achieving long term goals and peace of mind. We want to help our clients achieve their financial goals while being able to sleep at night. We believe that slow and steady wins the race.

The Internal Rate of Return

Typically, we will report investment performance as the Internal Rate of Return. This is a fancy way of saying that the rate of return includes the timing effects of contributions and withdrawals. If you add money to your accounts after a significant market upswing you will not get as much performance as if you added the money just before the upswing. This is the least exciting way of reporting investment performance, but the most important. It tells us how fast you are approaching your financial goals.

Let’s return to year 1 or your discussion with your neighbor. By June you are convinced you should invest with your neighbor’s investment guru.

Total Return Their Investment Your Investment
Year 1,Jan – Jun 25% 125,000 You invest in June.
Year 1,July – Dec 15% 140,000 $115,000

Even though the investment manager can lay claim to a 40% return, your investment only picked up a 15% return (due to the timing of your investment). Again, it’s very likely that the number you will talk about is the 40% year-to-date return (known in the investment business as the Time-Weighted Rate of Return). However, it’s the Internal Rate of Return (15%) you will have to live off of.  (We have simplified this example to some extent so that we do not get bogged down in the more esoteric details of reporting investment performance.)

Evaluating investment performance can be a challenging endeavor.

Learn more about our Investment Management Services, or schedule a time to speak with an advisor.

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