Why measure your portfolio?

I recently measured and reported on the results of the Cognitive Investing Demonstration Portfolio (www.cognitiveinvesting.com/demonstration-portfolio) for the second quarter of 2012.  What is the point of this exercise?  What can we learn from it?  Should you be doing something similar with your own portfolio?

The answer is a definite yes.  Many investors, however, neglect this essential task.  Some take a look at their portfolio and skimp on the process, looking only at the bottom line.  They are doing themselves a big disservice and are passing up an opportunity for improvement of their portfolio management process.

If you are not collecting the most fundamental and basic data about your portfolio’s performance or current condition, how can you expect to make anything resembling an informed decision?  How will you know if you need to change something about the process?  How will you know if the costs you are incurring are reasonable?  How will you know what to do when the market conditions change or when your personal situation changes?  If you don’t know where you are, what direction you are going, and what kind of progress you are making along the way, you should not be surprised when things don’t turn out as well as you think they should.

Some overconfident investors don’t see the need to take such periodic measurements because they “know” that they are above average investors.  After all, they can easily recall some of their best trades, which made far higher returns than the market averages.  Take for example Bragging Bryan.  He bought XYZ Corp. two years ago at a price of 10 and the stock is now 18.  He made 80% in two years.  That is a great return.  He tells his friends about what a smart pick that was.  Of course, XYZ Corp. was only a small portion of his portfolio and the rest of his picks did not do nearly as well.  Some of those other stocks he bought he would prefer not to discuss at all, since that would force him to confront the truth that he lost money on those.  Bryan judges his performance by examining only a few non-representative holdings, which is a good way to obscure the truth.

Disorganized Dan never evaluates his portfolio because it requires too much effort.  He has multiple accounts including a 401(k), several IRAs, and a taxable account.  His wife also has additional investment accounts.  He takes a quick glance at the statements when they come in and figures that he will do ok without trying to consolidate any of the information across all of his accounts.  He is not concerned that many of the positions in his various accounts overlap.  To his way of thinking, each decision made sense at the time, so the sum of all those decisions should not be a problem.  Organizing his finances is about as enticing to Dan as cleaning out his garage.

Both Bragging Bryan and Disorganized Dan are ill equipped to answer many of the important questions about their financial future.  For example,

  • How much of the increase or decrease in the value of their portfolios is due to the addition or subtraction of new funds and how much is due to their investment returns?  How do their investment returns compare with market averages?
  • Is the lack of attention they pay to their portfolio hurting their returns?  By how much?
  • Are their portfolios adequately diversified?
  • Are they paying too much in management or transaction fees?  Are they paying too much for advice?
  • Do their portfolios have the yield characteristics they require and are reasonable given current market conditions?
  • Are their asset allocations appropriate?  How have they changed over the last several years?
  • Are any adjustments to the portfolio needed?
  • Are the additions to or subtraction from the portfolio of sufficient magnitude to accomplish the goals of the portfolio?
  • Are they on track to meet their long-term goals?
  • Do they even have defined goals, other than to “have more money?”

The process of measurement may also bring up other important issues that are outside the scope of what is being measured.  For example, figuring out whether your portfolio’s progress is adequate for future goals requires that some sort of future goal has previously been defined.  If such a goal has never been defined or even considered, then periodically taking portfolio measurements might be beneficial by forcing one to answer some of these more substantive questions.

The value of this measurement process accrues over time.  If you are diligent, then you can track important parameters over longer periods of time, and they can provide a good check to make sure you are basing your decisions on real facts and not misperceptions.  For example, if you track cash inflows (or outflows) for five years, you will get a good sense for reasonable amounts of money that can be added (or subtracted) from the portfolio under a variety of conditions.   You can see how a portfolio grows over time and you can also get a sense of the magnitude of the shorter-term fluctuations along the way.

So what are the mechanics of making intelligent measurements?  What data should you track?  How should you interpret the results?  How rigorous an analysis is needed? What are reasonable benchmarks?  How often should you go through this process?  The answers to these questions will be the topic of the next essay.

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