This seems like it should be an easy question to answer, but in fact it is very difficult. There are a few ways to look at the question.
Compare to Need. This is the easiest way to measure performance. Let’s say you have created a detailed financial plan that says that if you earn 5% average rate of return on your money, you will be able to achieve all of your goals (assuming a 3% annual increase in the cost of living). Periodically you look at the total amount of assets you have available, compare to the plan and see that you are on or ahead of the projected path. You might choose to sit back and relax and assume that all is well.
The beauty of this approach is that it frees you from chasing returns by taking more risk than you need to take. Who cares what the stock market does? As long as you average 5% return year after year, you can relax, right?
The problem with this approach is that it doesn’t look at how much risk you are taking to earn the return you are earning. Consider
Compare to Your Neighbors. Your neighbors brag about the hefty returns they earned on the stock portfolios in 2013 and 2014. There is some temptation to compare your own results to their reports of fabulous returns. If they can earn those returns – why can’t you? After all, isn’t keeping up with the Joneses our national pastime?
The problem with this approach is that neighbors only tell you when they are doing well. No one brags about their investment IQ when their portfolio is down 25%. Again, what is missing (as with above) is a measure of risk.
Compare to “The Market”. To most people, “the market” means the S&P 500 index. But does this make any sense? Some years the S&P 500 performs spectacularly – such as 2013 and 2014. In those years, the only way you could keep up with the S&P 500 is to invest in an S&P 500 index fund. Other years (2000-2002, 2007-2008, and…at least so in 2015) the S&P trails most other asset classes and you could beat the index with bank CD’s. About the only portfolio it makes sense to compare to the S&P 500 is an all domestic stock portfolio. If you are in a diversified portfolio (as most investors are) then comparing to the S&P 500 index tells you more about how the S&P 500 did than how your portfolio performed. If your diversified portfolio exceeded the S&P 500, then the S&P likely underperformed other investments (like bonds, international stocks, real estate, etc.). If your portfolio underperformed, chances are the S&P was flying pretty high.
The importance of measuring risk. The problem with comparing any portfolio to ANYTHING else is that you can’t compare performance without comparing risk. Consider the following two portfolios – both of which produce the exact same return over a five year period, and see which one you prefer:
|Year||Portfolio 1||Portfolio 2|
OK, let me save you the math. Both portfolios generated an average return of 5%. But almost any rational person would have preferred Portfolio #2 during this time period, all other things being equal. Why? Because although past performance can’t predict the future – it sure seems likely that the risk of a big loss is much bigger in Portfolio 1 than in Portfolio 2. More importantly, I was not paid to take on that risk – I earned 0 excess return. An investor in Portfolio 1 could have done just as well in another portfolio and gotten much better sleep at night.
How to Incorporate Risk into Portfolio Performance Measures.
Comparing to Need. As we just demonstrated, not all 5% portfolios are created equal. To what extent can you anticpate that you will continue to receive 5% in the future? How exposed is your portfolio to a future market shock? Considering the past “volatility” or variability in returns can help answer these questions – but you can’t do this solely by comparing your average return to what you hoped to receive.
Comparing to your Neighbors. If I am in portfolio 2 and my neighbor is in Portfolio 1, chances are he is trying to mock my relatively modest return in year 3. He conveniently forgets his dreadful result in year 2, and is overexposed to risky investments which will cause him to give back most of his stellar return in year 4. But unless my neighbor shares his IRA statement with me, I don’t know how much risk he is taking compared to my own portfolio – so any comparison is pointless.
Comparing to an Index. There are two ways to incorporate an allowance for risk into a benchmark comparison. First you can compare to a blended index which you believe should have a risk profile that meets your own investment goals. More knowledgeable investors will look at something called “risk adjusted return”. When looking at a portfolio analysis report for the above two portfolios, Portfolio 1 would have a much lower “risk adjusted return” than Portfolio 2. It would in effect be assessed a performance penalty for the additional risk it took on. One commonly used measure of risk adjusted return is a statistic called “Alpha”. If a portfolio analysis report shows a portfolio has a positive “alpha” compared to a benchmark that means that the return after adjusting for risk is favorable.
This may be more detail than most investors want to go with their statistical analysis – but we need to go there if we want to compare your portfolio performance to any benchmark. Otherwise, you are prone to making the mistake of sitting in Portfolio 1 thinking you are doing just fine because your long term rate of return is the same as Portfolio 2!
NOTE TO FINANCIAL PATHWAYS INVESTORS. For all the reasons described above I will be changing benchmarks on performance reports this quarter and next to offer a more risk appropriate performance comparison. For instance, income portfolios will be compared to a blended index that is 40% stocks and 50% bonds and 10% cash. Moderate portfolios will be compared to a blend that is 60% stocks, 35% bonds, and 5% cash, while Growth Portfolios will be compared to a blend that is 80% stocks and 20% bonds. Some of you may see the new benchmark on this quarters reports, others may not see it until next quarter.