Client Question – Performance

December 14, 2023

A client reached out this week to inquire about her performance (rate of return) since we started working together. As I drew her attention to that section of her quarterly reports, I also explained a couple of things to keep in mind when calculating and evaluating performance returns. These are important concepts for all investors to understand, so let’s dive in!

What is a rate of return?

When it comes to an investment portfolio, your rate of return is the change in your account value (excluding any contributions or distributions from the account as those cash flows, while they impact your balance, don’t impact performance). The rate of return is therefore driven by a combination of income (dividends and interest), appreciation/depreciation (change in the price of the security) and fees (management fees to an advisor, trading costs, margin interest, etc)

How do I calculate the return?

For our clients, we use a performance reporting software that allows us to calculate returns on a daily basis that are then used to determine returns for any given time period (days, weeks, years, etc). This allows us to precisely account for the timing of activity and thereby giving us the most precise return.

If you are investing on your own, your custodian may have tools that will help you see your performance or they may list it on your statement. You can always do a rough calculation on your own (ending balance less beginning balance/beginning balance). Keep in mind that such a calculation will not be 100% accurate as it doesn’t take into account the exact timing of activity (unless you calculate it daily) and be sure to adjust for any money in/out as those flows are not a part of returns.

Also, if you are calculating a return for a period in excess of a year, be sure to annualize that return (ie: convert it into a per-year return). Doing so allows it to be a relevant number that can be easily compared

How do I interpret a return?

This is perhaps the hardest thing for investors to understand when it comes to evaluating performance. Many look at performance returns in absolute terms, simply viewing as positive return as “good” and a negative return as “bad.” On the surface that makes sense, but what if you earn 5% when a comparable portfolio earns 20%? Or what if you lose 2% when a comparable portfolio loses 13%? In those cases, a positive return is bad and negative report is good.

The above illustrates why it is very important to evaluate returns on a relative basis (ie: compare them to something). But don’t compare them to an arbitrary number like the headlines on the news or what your neighbor tells you they earned at a dinner party. Neither of those metrics are relevant to you and your portfolio.

Instead, you should compare your return to a relevant benchmark for your portfolio. A benchmark is the blended index/market return a portfolio comprised of the same allocation as yours. Let’s say your target allocation based on your goals and circumstances is: 5% cash, 25% fixed income, 70% equities. Your benchmark could then be (5% * 90 day T Bills return) + (25% * Barclays Agg Bond index return) + (70% * Russell 3000 return) over the same time period. Notice that in this instance, your benchmark is not just the S&P 500, the NASDAQ, a money market return, or what your family member made in Bitcoin.

This relative comparison against a meaningful and representative benchmarks allows you to truly evaluate how your portfolio is doing.

How should I react to performance variances?

This is always a challenge for investors, myself included – what should be done with the actual vs benchmark evaluation.

For most of us, there will be times when your portfolio lags your benchmark and you feel the need to react and adjust. It’s just the way markets and investing work.

This variance can be caused by being under/over weight a part of your allocation or by the securities in a given asset class under/out performing the broader index. It is simply not uncommon for you to be offside your benchmark in any given month, quarter, or year – either on the upside or the downside.

I always suggest evaluating longer-term performance (vs. any given shorter period). Look at that longer-term performance and compare it against your benchmark, as well as the ability to meet your goals with that level of annual return.

Performance is one metric to consider when looking at your portfolio – but not the only one. Be sure to calculate the return appropriately, compare it against a meaningful and customized benchmark, and evaluate it with a long-term perspective in mind.

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