I hear it all the time. Having lunch with a friend, “My portfolio is up 15%” or from a friend at another financial firm, “Our portfolios are up 10%”. My initial reaction is to do a quick back of the napkin comparison. Reality sets in and I start asking questions to better understand what they are talking about. What I realize is they are quoting raw returns. The raw return is the return over a past time period (such as 6 months, 1 year, etc.), without adjusting for risk. Looking at only the raw return can twist your perceptions about how your portfolio is performing and lead you to bad choices – i.e. taking on more risk or flip-flopping from one investment strategy to another.
Wall Street knows this. The greatest marketing tool used by slick talking salesmen is convincing investors that historical returns are predictive. They aren’t and may they never will be. Beware the salesmen touting their portfolio returns. There’s a good chance the returns they crow about were cherry picked to highlight their best performing investment strategy or their high-risk, high-reward portfolio which just happened to do well over the particular time period.
The same holds true when discussing returns with a friend or trying to compare your return to that of an index. When a friend brags about their investment return, there’s a good chance you’re not getting the full story. While it may elicit envy, there is no reason why your portfolio returns should be comparable to that of your friends.
And, trying to compare your returns to an index, same result. These benchmarks provide useful information about how the broader market is performing, but they are less useful for understanding how your personal portfolio is performing.
Here are a few of reasons why your portfolio return can vary significantly from the returns touted by a salesman, your friends or an index. Understanding these differences can help you assess the performance of your portfolio and, more importantly, lead you to ask pertinent questions of the salesman or your friends.
- Asset allocation - The biggest contributor to your long-run investment return is your portfolio’s asset allocation. Two important factors in designing any portfolio is first, deciding which asset classes are to be included and which are expressly not included. The second is determining the long-term weightings for each of those asset classes. Other factors include tactics to try to capture excess returns through altering the strategic mix of assets (market timing) and identifying mutual funds, ETFs or individual securities that will outperform over time (security selection). Ask the salesperson or friend what their portfolio’s asset allocation strategy is and how they tactically manage it. Ask for information about how their portfolio performed in down markets as well as up markets.
- Risk level - One of the key factors driving an asset allocation model is the level of risk (i.e. volatility) that is associated with it. A 25-year-old just starting out should have a vastly different risk profile than an 80-year-old who looking to preserve their assets. Then again, an individual who started saving later in life may need to take on additional risk in order for their financial plan to work out. Ask the salesperson or friend what the risk profile is for the model they tout and then assess how it aligns with your unique life situation.
- Performance measures and timing of performance return - For individuals, the most accurate performance measure is the dollar-weighted return method which includes cash flows in and out of the portfolio through time. When cash comes into or out of a portfolio can have a tremendous impact on portfolio returns. The performance measure most commonly used by mutual funds is time-weighted returns which strip out the impact of cash flow. Timing of portfolio returns can be tweaked as well. Portfolio returns will look much better if the starting point is the market bottom of 2009. The market has risen roughly 300% since February 2009 so make sure you ask the salesperson or friend the time period for which the portfolio’s return is being calculated.
For the reasons cited above, it is very difficult to compare investment performance results for different investors. To stay on track to achieve your financial goals, it is best to devise an investment portfolio that is appropriate for your unique situation, devise an appropriate benchmark and track your portfolio’s performance against that benchmark.