As the old saying goes, there are lies, damned lies and statistics. And then there is investment performance, which may deserve a category of its own.
This topic came to mind recently when I saw a press release heralding the accomplishments of a retired non-profit 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? Or was it the endowment manager that was brilliant? Or did his 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 surrounded by claims about investment performance, and it can be hard to make sense of it all. To help you navigate the numbers, below is a five-step guide to interpreting investment performance.
Step 1: Understand the sources of growth
The first step is to understand the basic math of an investment account. It looks like this:
Beginning balance, January 1
Plus: Increases or decreases in the value of your investments
Plus: Interest and dividends paid by your investments
Minus: Investment fees
Equals: Ending balance, December 31
In addition, though this won’t show up on your statement, you should also subtract the taxes generated by your investments. That will leave you with the most realistic picture of your investment 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 over the course of the year, then 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 over the course of the year. 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. It’s a confusing term, but the idea is that it isolates your investment returns from the distortions of contributions, withdrawals and fees, allowing you to measure your true investment return. Whether you’re grading your own investments or evaluating a prospective investment, you always want to look for time-weighted returns. That will allow you to make apples-to-apples comparisons, as explained in Step 3.
Step 3: Put your returns in context
Once you’ve isolated your investment returns, the next step is to compare it to a relevant “benchmark” such as the S&P 500 Index (for stocks) or the Barclays Aggregate Index (for bonds). There is nothing magical about these, or any other, benchmark. What’s important, though, is that they provide you with a yardstick for comparison.
How should you use this yardstick? 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 (Microsoft, Apple, Amazon, etc.), then 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 separately.
If you’re evaluating a mutual fund, you want to be especially careful. The mutual fund operator will provide a benchmark for comparison, but I’ve found it’s useful to take their recommended benchmark with a grain of salt. Stand next to a tortoise, and you’ll look fast. Stand next to 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. Unfortunately, you won’t know this until after the fact—when your tax return is completed. Since we’re coming up on April 15th, though, this is a good time of year to review this. Open your tax return to Form 8949 to see if any of your holdings are generating disproportionately large tax bills.
Step 5: Take a step back
Some years ago, a colleague asked this question: “What in the world does the S&P 500 have to do with my financial plan?” It was a good question. As much as it’s important 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 so that I can sleep at night? That, in the end, is probably the best measure of success.