My dad had a brief stint as a land surveyor. Even a decade later, he was still able to eyeball distances and pace out yardage with, at least to a young child, surprising accuracy. Later when I was in high school, I can also remember him pacing something out and my mother interrupting him: “Why aren’t you using a tape measure?” Strangely enough, the tape measure told a fairly different story than my dad’s pacing. In hindsight, he probably just didn’t want the trouble of digging the tape measure out of his toolbox.
Sometimes I think people take a similar approach to measuring investment performance. We look for the quick, simple answer to “How are we doing?” At first glance, measuring performance of investments is crystal clear. “How much has my account gone up?” And to be fair, that is usually what matters most to investors.
But if you are trying to truly measure performance–how you, your investments, and your advisor are actually doing–it is worthwhile to, as Rafiki tells Simba in Lion King, look harder. Otherwise, you can wind up with a skewed or incomplete understanding of how investments are doing.
In the investing world (especially for long term goals where we can invest in companies and their stock), performance is something that we realize over many years or even decades. It is truly a mismatch that such a long-term proposition as investing in a company can be measured by looking at a stock’s price every day or even every minute. It is tempting to pull out the ruler when you should be measuring with an odometer.
The right approach takes a lot of patience and a certain disregard for the daily, monthly, and even yearly gyrations of market activity, as I have written about before. That said, we do need to periodically evaluate our progress. To do so, you need appropriate benchmarks. You need to use the right tape measure.
A great example: the S&P 500. Far too many people (advisors included) compare their portfolios to this. As a quick reminder, the S&P 500 tracks the performance of 500 of the largest publicly traded companies in the US. Untold numbers of investors in retirement have become frustrated seeing how the S&P 500 is growing faster than their own portfolio. Why am I missing out? Why shouldn’t I just invest in that instead?
The trick is to compare apples to apples. I would be unhappy too if I bit into an orange while expecting the experience of an apple. Similarly, most retired investors are not investing with the intent to be 100% invested in the stock market. Even for those who are, they are typically not trying to invest purely in the largest companies in the US.
Let’s unpack this: imagine some common goals people have. You might be retired and seeking income, saving for a home purchase next year, putting away money for a child’s college tuition payments in three years, finally purchasing that dream boat next month, or making a meaningful donation to that favorite non-profit of yours sometime before year-end. In any of these situations, we need to heed not just the potential for growth, but the potential for volatility. We need a certain amount of money at a certain date in the not so distant future. We need some stability. This means that we should almost never be investing 100% in stock for any of these goals. Money markets, CDs, bonds, structured notes, or even cash…something has to be introduced to limit volatility. The tradeoff, of course, is less opportunity for growth.
This is why our rate of return cannot be the only metric we use to decide if our performance is good or bad. An 80% stock and 20% bond investment account is over time unlikely to grow as much as a 100% stock portfolio. We deliberately introduce other investments that won’t gain as much in exchange for increasing the likelihood of reaching our goals. The bond part of the account might prove to be our source of income for a year or two if the stock market has a rough patch and needs time to recover. The CD you own ensures the property tax bill you need to pay in a few months will be taken care of, no matter what Elon Musk or your blustering neighbor have to say on the matter.
We know this–so we need to be careful about trying to compare the stock market and your portfolio as if they are the same animal.
Let’s also discuss those goals where it does make sense to be 100% invested in equities (stock) because the timeline is far away and we don’t mind current fluctuations. It still may not make sense to use the S&P 500 as our benchmark. The US has been a wonderful place to invest, but we may want to invest outside the US as well. If the US has a rough spell and the rest of the world does comparatively better for a few years, we will be glad we opened our horizons and portfolios to opportunities outside our borders. If two kinds of investments move in opposite directions but both grow over time, we tend to experience a smoother ride than if we owned just one or the other. Here is a figurative example of how that works:
This isn’t just meant to make us feel better, either: for someone taking income from a portfolio, the smoother portfolio tends to last longer than the portfolio that spends large portions of time temporarily down–even if they both wind up with the same rate of return in the end!
When we evaluate performance, we thus need to take a look at how stable the investment was in addition to how much it grew. If two investment portfolios both gained 7% a year but one thought it was Tom Cruise from Top Gun in his fighter jet doing nose dives every other month while the other steadily gained, there is an obvious winner.
So how do we measure performance?
In the end, the only thing that truly matters is whether you were able to hit your goals or not. If you hit that, the rest is essentially a wash anyways. But if we are trying to evaluate performance along the way, we need to look at two main things:
- How are we doing compared to similar investment mixes? If I own an investment account that is 40% dogs, 30% cats, and 10% birds, I want to look at the average account benchmark that is also 40% dogs, 30% cats, and 10% birds. If your account is more volatile and growing less than that average is, there is probably room to improve. If your 70% US-based stock and 30% foreign-based stock is matching or beating an index that is 70% US stock and 30% foreign stock, then your performance (as long as that is the right kind of investment mix for your goals) is probably pretty good! Keep in mind that indexes have no costs, which means even matching their performance is actually fairly impressive.
This allows us to evaluate performance even when unusual things happen. When COVID hit, almost everyone’s portfolios took a dive. If all you looked at was whether your account was positive or negative, you would have been quite disappointed and reached the conclusion that your investment mix was a bad one. But if you looked deeper and realized that your account was down, say, 12% instead of 20% like other similarly invested portfolios, you would reach a different conclusion!
- How is my performance taking into account when I invested? Classic example: you invest $100,000 and your investments grow 12% in 6 months. “This is great,” you tell yourself. “I should invest more!” You give your hard-working financial planner the green light to invest another $400,000 from the recent sale of an investment property into the growth portfolio he has put together.
Over the next 6 months, your investments fall 4%. If you only look at how much money you made, you would be negative! But your investments themselves would have grown 8% in a year! Your well-meaning financial planner (who shouldn’t be trying to game the market and guess when the market is going to go down and up from month to month) chose investments that gained 8% in a year, but he couldn’t control when you decided to add money into investments.
On a related note, we also care about when you are investing because of inflation. If your account grew 13% in a year, most people would be pretty happy. But if inflation was a whopping 9%, your real rate of return would only be 4%. Meanwhile, if inflation was 1% and your account grew 6% the next year, your real rate of return would be 5%--technically better than the first scenario despite your account’s value going up more than twice as much!
Evaluating performance can be confusing, but we can help walk you through it. We don’t mind talking about performance and want to make sure you understand exactly how well you are doing. For many clients, they prefer to focus on other things–like saving in taxes or talking about big changes in their life. We also encourage clients not to dwell too long or often on their performance; it can be counterproductive to over-analyze too.
But investment performance is something we absolutely need to review from time to time to ensure we are delivering on our promise to help you and your family be financially successful.