Are you Evaluating your Investment Performance Properly?

Investment portfolios come in many different shapes and sizes. The variables that go into determining the correct composition are nearly endless – time horizon, risk capacity, risk preference, and tax sensitivity (to name a few). And that’s not even counting biases like industry preference, geographic region, socially responsible preferences, and countless others. All things considered, virtually no two portfolios will ever look the same, so what can an investor do to figure out how well they’re doing?

Behavioral Benchmarking

First, a pop question: let’s say that your portfolio earned 10% over a year. Is that good? Take 3 seconds to answer the question in your head before reading on… Seriously, answer the question in your head.

If your answer was “yes,” or “no,” or really anything other than “it depends,” then you should definitely keep reading because this is a fatal error that you should avoid making in the future for the sake of your wealth. There’s no real industry term for this mistake, so for the purposes of the article I’ll call it “behavioral benchmarking.”

In the example above, a 10% return can be good, bad, phenomenal, or terrible, and before one can come to a definitive conclusion, at the very least the following questions should be asked:

• How did the stock market do over this same time period?
• What is the risk exposure of the portfolio?
• Where are interest rates?
• What does inflation look like?
• What are the client’s individual needs?

So for the love of everything you hold dear, please remember this – whether you earned a positive 20% or negative 20% return in a year, that really doesn’t mean anything about whether your portfolio is doing well or not.

Relative Benchmarking (Simple)

One step in the right direction would be to compare the performance of an investment portfolio to a standardized benchmark looking over the same period of time for both. A very common benchmark in practice is the S&P 500 index, which tracks the performance of large companies in the US, and is often referred to as “the stock market.” As an example, if your portfolio earned 10% but the stock market returned 20% in the same period of time, are you doing well?

Once again, it depends! I really wish this practice went away in the industry, because benchmarking a portfolio to the S&P 500 only makes sense if the portfolio is invested 100% in large US companies. The reality is that most portfolios hold other asset classes, like bonds, international stocks, commodities, etc… Bonds typically make a portfolio more stable and conservative compared to equities, making it inappropriate to benchmark a portfolio containing them to a singular equity asset category like large US stocks.

Relative Benchmarking (Diversified)

Another step in the right direction would be to comprise a benchmark that corresponds to the composition of the different asset categories (asset allocation) in the portfolio. As an example, if your portfolio is comprised of: 40% US stocks, 20% international stocks, and 40% bonds, comparing the performance to a similarly weighted set of the indices corresponding to those asset classes isn’t a bad idea. At the very least, you have will have an idea of whether your chosen investments or funds are overperforming or underperforming their respective markets – this is known as alpha.

So what are the two flaws with this approach? Well firstly, who’s to say that you should have the asset allocation that you currently have? Perhaps you have “too much” US exposure (known as home country bias), or you have “too much” in an asset class like commodities. I put “too much” in quotes, because there’s no way to give a definitive answer as to what an asset allocation should look like without taking into account all the other variables and biases mentioned in the second paragraph of this article. As an example, the same 40/20/40 (US stocks/international stocks/bonds) portfolio might have outperformed its relative benchmark, but could have underperformed another portfolio allocated 20/40/40. Over time, it would have certainly underperformed a portfolio allocated 70/30/0. This brings me to the second flaw with relative benchmarking – the performance relative to an index or even a diversified set of indices should not matter to an investor.

Personal Benchmarking

One more time, because it really can’t be said enough, the performance of a portfolio relative to an index or even a diversified set of indices should not matter to an investor. This may fly in the face of many investment advisors around the world, but it’s a fundamental truth when it comes to personal wealth management.

So Leon, you ask me, how the heck do we know whether our investments are doing well or not? The answer is simple, but the execution of it is challenging. You must first identify what you are investing for. You need to have a financial plan that outlines, at the very least, how much money you will need, when you will need it, and how long you will need it for. With that target in mind, coupled with your savings pace, you can then compute what your personal rate of return needs to be for the plan to succeed. That personal benchmark is what you should be comparing your portfolio to, and that’s one of the practices you should be holding yourself or your financial planner to doing regularly.

To paraphrase the legendary financial guru, Nick Murray, you must invest in your financial goals. Anything else is gambling and speculation. Your benchmark, therefore, must be in service to those goals – your goals! Are you meeting your benchmark or not? That is the question. All other comparisons are folly, and worse, a distraction and diversion from the goals you have set out to achieve.

All investments carry some level of risk including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against loss.

Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) (life and disability insurance, annuities, and life insurance with long-term care benefits) and its subsidiaries. Leon Baburov is an Insurance Agent of NM a Registered Representative of Northwestern Mutual Investment Services, LLC (NMIS) (securities), a subsidiary of NM, broker-dealer, registered investment adviser and member FINRA and SIPC.

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.