How should a portfolio be measured?

In the previous essay, I discussed why it is imperative to measure your portfolio periodically.  In this essay, I will describe how to measure its most important characteristics.

The first principle is to measure the whole portfolio as an entire unit, and not just focus on a particular subset.  What matters is the forest, not the trees.  Sometimes this is difficult because portfolios can get complex, especially for those investors who have multiple accounts.  But it is imperative to consolidate all holdings and look at the entire picture.  Focusing on a subset of the portfolio is likely to give you a distorted picture of what is really going on.  This can present either an overly positive picture or an overly negative picture depending on the mindset of the investor.  For example, in the most recent quarter, stocks had a negative return and bonds had a positive return.  Someone who focuses only on the stock portion of the portfolio could get a misleading impression that they had lost a lot of money and the prospects for regaining it are very much in question.  Someone who only considered the bond portion would think everything was perfectly fine.  The proper viewpoint, of course, is to take both components into consideration.

The value of the entire portfolio is the most essential piece of data.  No intelligent decision can be made without knowing this number.

The next item to measure is the portfolio’s allocation.  The portfolio should be categorized and the percentage composition of each category measured.  Cognitive Investing fully describes the rationale and benefits of this process.  The key concept is to keep allocations fixed, which requires periodic rebalancing.  For more on this topic, see my posting from last year, “The importance of a fixed asset allocation.”

Once the total value and its component allocation measurements are made, it is a good idea to make a permanent record of them, so that they can be compared to the corresponding measurements taken at an earlier or later time.  By comparing the total portfolio value from two or more different dates, and doing a small bit of analysis, you will get two more essential pieces of data which are helpful to make informed investment decisions.  The first is the effect of the additions to or subtractions from the portfolio.  The second is the performance of the portfolio.  These two items must be considered together since they are interrelated.

For example, let’s say your portfolio’s value was $10,000 at the beginning of the year.  At the end of the year it is $15,000.  If you neither added nor subtracted money from the portfolio during the year, your return is 50% ($5,000 gain divided by an original amount of $10,000).  This is stellar return and highly unlikely.  If you examined your financial statement, you find that you added $4000 during the year.  So the portion of your gains due to the increasing value of your investments was $1000 ($5000 – $4000).  Your investment return was 10% ($1000/$10,000).  (Note for those accountants out there: This calculation is imprecise because it does not take into consideration when during the year the money was added, but it is accurate enough for the task at hand and will suffice for most individual investors.)

Tracking the amount of money added to or subtracted from a portfolio will help immensely in the long-term planning process.   By measuring the inflows and outflows, you will get a true picture of savings and withdrawal rates.   Without knowing what are reasonable savings and withdrawal rates, it is difficult to answer questions like, “How much money am I really saving?” or “When will I have enough money to retire?” or “How much money can I safely withdraw from my portfolio?”

Measuring portfolio performance is straightforward.  Interpreting the results, however, can get much more complicated.  Some investors might be satisfied to do a quick comparison of their results to a benchmark.  Others might want to do an in-depth analysis of their results to uncover ways to adjust their portfolio to increase the probability for higher returns.  The question investors should be asking themselves is, “Is my portfolio performing as well as it reasonably should, given the current market situation?”  To answer this, we must delve into the details of benchmarks.

The default mental benchmark is a 100% cash portfolio.  Naïve investors compare their investments to a simple alternative: what would have happened if I left everything in cash?  If the portfolio value goes up, they rejoice because it performed better than the total cash portfolio.  If the portfolio value goes down, they become depressed because they would have been better off not trying to invest at all.  Many investors make this comparison without really considering its underlying logic.  For most investors, keeping all of one’s assets in cash makes little sense, since cash typically loses purchasing power over long periods of time after inflation and taxes are taken into account.  If your assets are at least twice what you will ever need, then a 100% cash portfolio might be a reasonable alternative for comparison.  But for most investors, a total cash portfolio is not a viable basis for comparison.

When I report quarterly results for the Cognitive Investing demonstration portfolio, I first state the absolute performance of the portfolio for the quarter.  I then compare that to a number of benchmarks: the S&P 500, the average stock fund, the average bond fund, an international stock index and the total U.S. stock market index.  This group of benchmarks describes how various discrete sectors of the market performed.  None of them are “investable,” meaning that it is not possible to purchase shares in the S&P 500 index or the average bond fund.  Indexes do not include costs of managing an actual fund, and you can never buy the average stock or bond fund, since you don’t know beforehand which ones will be average.  But the performance of indexes and the average fund provide valuable data for comparison purposes.  If stock indexes and the average stock fund goes up, but the stocks (in aggregate) in your portfolio do not, then there is an issue that needs addressing.

Note also that there is no single benchmark that is suitable for comparison for an entire portfolio.  A well-diversified portfolio will have a mix of stocks and bonds from the U.S. and other countries. Any benchmark that included every asset class would likely not partition them in the same way that is appropriate for your portfolio.  So to make the most useful comparisons, it is helpful to use a group of benchmarks that most closely resemble the categories of securities in the portfolio.  In the first quarter of this year, the demonstration portfolio underperformed the average stock fund by 3-4%.  But it outperformed the average bond fund by 6-7%. The opposite situation occurred in the second quarter.  If you consider a blended benchmark of roughly twice as much stock influence as bond influence, then the portfolio performed in line with the blended benchmark over both periods.

One note of caution: The “raw” value of a stock index does not take into account the return from dividends.  If you compare the S&P 500 index value from 10 years ago to the present and compare it to your portfolio’s return, you are making a very large mistake.  Your portfolio return includes all dividends, whether reinvested or not.  The difference in the index values does not include any return from dividends. Over long periods of time, this can make comparisons very misleading.  To correct for this, I recommend using an investable alternative as a comparison.  For example, if you wanted to compare your portfolio to the S&P 500, you could use an S&P 500-based ETF, such as SPY or IVV.  For the whole U.S. stock market, you could use the Vanguard total stock market ETF, VTI.  These securities pay dividends and any comparison should be done with historical information that includes the returns from dividend payments.

For the demonstration portfolio, I track each component’s quarterly return including dividends.  This is probably more involved than necessary for most investors, but it helps to illustrate how closely a purchasable security tracks an index.  For example, in the first quarter of this year, the EAFE (Europe, Australasia, Far East) index increased 10% and the fund that tracks that index, VEA (Vanguard Europe Pacific ETF) increased 11%.  In the second quarter, the index declined 8.4% and the fund declined 7.2%.  In both quarters, the fund outperformed its targeted index. (I don’t know how they did this or whether such outperformance will continue, but those are topics for a different essay.)

There are numerous reasons why a portfolio’s performance will stray from the performance of an index.  It is not always easy to discern the underlying causes of such a diversion.  The number and nature of the securities in the portfolio can frequently offer clues.  If there are only a few holdings, they may not be representative of the entire category.  For example, I would not expect a portfolio that consists solely of Apple and Microsoft stock to perform in line with any broad-based stock index, since two individual stocks are likely to diverge quite a bit from overall averages.  Another facet of a portfolio that can affect comparisons is the turnover rate.  If you are doing a lot of buying and selling, that can have a much bigger influence on the portfolio’s performance than the movements of the underlying markets.  Comparing performance to broad-based benchmarks can be a good way to judge whether your buying and selling added or subtracted value.  If you are like most investors (professionals included), the more you buy and sell, the more value you subtract.

Another item that you might want to measure is your investment costs.  This is typically not something that would need to be measured at every periodic point, but more of a one-time event that can highlight the effect of costs on performance.  Two main categories are the expense costs of owning funds and transaction costs of buying and selling securities. I recommend calculating these costs in both percentage and dollar terms.  The costs expressed as a percentage of the whole portfolio’s value is helpful to determine whether you are paying a reasonable amount based on the size of the portfolio.  Viewing these costs in dollar terms is much more likely to evoke an emotional response, and can highlight how much of your investment return is captured by toll collectors in the finance industry.  I cover the issue of costs in more detail in chapter 30 of Cognitive Investing.

The answer to the question of how often you should make these measurements is the most frequent answer in all of personal finance: “it depends.”  It depends on how complex your portfolio is, how engaged you want to be with the process, and what your goals are.  I suggest that everyone should do this at least yearly and those with larger or more complex portfolios should do this quarterly.  For those who are heavily engaged in the process, monthly is about as often as is ever reasonable.

Periodically taking these measurements is relatively simple, and the benefits that you can derive from a few simple calculations and comparisons dramatically outweigh the effort involved.  It can lead to your making much better investment decisions and give you a higher probability of achieving your financial goals.  So if you haven’t measured your portfolio in a while, do it soon.

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