July 25, 2018. By Mark Barry:

After a year in which almost all asset classes exhibited solid positive returns, 2018 has been mixed thus far with respect to performance across the financial markets. In the United States stocks are up, with small caps handily outpacing large caps, while both international developed and emerging market equities are in the red. The bond markets have also had a tough go, with the majority of sectors posting negative year-to-date returns. Given this divergence in asset class performance, we wanted to revisit the topic of performance measurement, i.e. how investors can evaluate if their portfolio is doing well.

Generally speaking there are two broad approaches to evaluating the performance of your portfolio, although it is important to note that these approaches are not mutually exclusive. The absolute approach involves setting an annual return target, for example 4%, that is sufficient to meet your personal investment objectives and goals. The return target is often set during the creation of a comprehensive financial plan and then the portfolio’s asset allocation and overall investment plan is designed to meet this return target.   Using this example, as long as your portfolio generates the 4% annualized return over the long-term, irrespective of how the Dow Jones, S&P 500 or any other index performs, you know you are on track.

The second approach is the relative or benchmark approach where you determine a benchmark to evaluate the portfolio against periodically. The key here is to select an appropriate benchmark – while comparing one’s portfolio against a blended benchmark consisting of the S&P 500 Index and the Barclays Aggregate Bond Index may shed some insight on performance, it really isn’t an appropriate benchmark for a well-diversified portfolio, as it only encompasses large cap US stocks and US investment-grade bonds (and mostly government bonds at that). In addition, to compare apples to apples, the benchmark must be adjusted to account for changes in the portfolio’s allocation. Did the portfolio become more conservative or aggressive from year to year? Did the portfolio maintain a large cash position for a possible home purchase or large anticipated expense that would be outside of the benchmark allocations? Or was their cash that was being dollar-cost-averaged into the market over a number of months? What was customized to your family needs that fell outside of the benchmark parameters?

Regardless of which approach may be used to evaluate portfolio performance, there are a few things we would like to highlight as especially important.  One, remember that all returns are not all created equal; two portfolios can have the same level of return yet with materially different levels of risk to achieve those returns. Investors should also put more weight on long-term performance figures as too much focus on short-term performance can derail even the best of investment plans. And lastly, make sure whatever benchmark you use to compare your portfolio against is relevant to your portfolio and investment objectives.

Comparisons of your portfolio performance against inappropriate benchmarks or to that of friends and colleagues can be confusing and frustrating. The details for such benchmark comparisons are critical and must include the macro view and plan.  Even if your buddy is actually earning 20%+ per year as he or she claims, this performance probably comes with an extensive amount of risk!