After making investments, it’s important to examine the quality of their performance. That applies to both trading and investing.
With trading, a trader needs to examine the cumulative returns of his trades across a set period of time. That way, the trader can know the overall impact of any loses or gains.
This is particularly important because traders don’t usually trade all of their money. Instead, they usually trade with a certain percentage of their overall money.
As a consequence, it’s important for them to track their cumulative returns.
The same is obviously true for a long term investor that has built a portfolio that is trying to outperform the market.
If an investor’s portfolio does not deliver returns that outpace the market, there is no incentive for that investor to waste time and money constructing a portfolio.
Alternatively, they could simply invest in a market index.
When assessing the performance of your investments, it’s important to calculate your real returns.
It’s common for investors to focus on the percentage on the screen, without any regard for associated costs that may have reduced the return.
The most fundamental cost for investment returns is inflation.
As long as inflation goes up, investment returns will be less than they appear to be on paper.
As a result, it is crucial that investor calculate the real rate of return for their portfolio.
To do that, investors simply need to subtract the inflation rate from the performance of their investments.
For example, if an investor receives a return of 20% from his portfolio and the inflation rate is 5%, the calculation would be 20% – 5%.
The answer is obviously 15%, which represents the real rate of return for an investor. This basically means that the investor’s money has grown in value by 15%.
Understanding the real rate of return is important for investors. If the inflation rate is greater than the return from their investment activity, then they have actually lost money.
An investment return of 30% might sound fantastic, but it doesn’t sound great if the inflation rate is 32%.
Luckily, the inflation rate is typically low in the UK. The Bank of England are trying to maintain inflation at 2% or below. Therefore, British investors only need to achieve a return of more than 2% to beat inflation.
A big concern for investors is that they are compensated for building their own portfolio, rather than by simply investing in the market as a whole via an index fund.
In order to ensure that the performance of their portfolio has remained competitive, investors need to use a benchmark.
A benchmark is essentially a group of stocks that an investor is trying to outperform.
More often than not, a benchmark tends to be an index fund as investors are usually trying to beat the market.
If an investor fails to beat their benchmark, it can often be a call to change stock selections. It may have been the case that they did not beat their benchmark due to a couple of individual stocks that can be replaced.
If a portfolio does not outperform a benchmark over the long term, the investor is best placed to simply invest in a market index instead.
So, if the benchmark returns 10% and an investors portfolio returns 8%, analysis needs to be carried out to try to explain why that may have happened.
If an investor beats their benchmark, then nothing should be changes necessarily as their portfolio is delivering above average returns.
If an investor’s portfolio beats the whole market, it’s called ‘achieving alpha’ in the world of investing. This will be explained in more detail in the ‘invest like a pro’ chapter.
As mentioned, most investors use a stock market index as their benchmark. However, this may not always be the most suitable choice.
Finding a suitable benchmark to mirror your stock selections is important. Otherwise you may assume that your returns are below or above average for the risk that you have taken on in your portfolio.
For example, it’s appropriate for an investor to use the market index as their benchmark if they are investing half of their capital in bonds.
This is because their portfolio has a risk profile that is much lower than the market index.
Instead, this investor should try to identify a benchmark fund that has a similar risk profile. Perhaps the investor could find an fund that invests in stocks and bonds.
Identifying a suitable benchmark is also important if an investor is specialising in a particular sector.
For instance, an investor may buy technology stocks only, which would mean that an index fund would be an inappropriate benchmark.
Therefore, the investor would be better placed to find and use a fund that invests in technology stocks as a benchmark. A suitable choice in this case would be the S&P500 tech fund.
The benchmark that you select should also vary depending on the country that you invest in. There’s no point using the S&P500 as a benchmark if you are only investing the UK (and vice versa).
This applies if you are investing in multiple countries too. Instead of using a market index from a specific country as a benchmark, it would be better to use a fund that invests globally as a benchmark.
In short, as an investor you need to select a benchmark fund that shares similar characteristics to your portfolio.
The frequency of when you evaluate performance is important. The standard case in the finance industry is that investors evaluate performance once a year.
With that said, it depends on your investment strategy.
If you are a trader, it may be more appropriate to evaluate your performance on a weekly, monthly or quarterly basis.
On the flip side, if you are a long term value investor, a one year timeframe would be most appropriate.
With that said, the seriousness to which an investor should make changes depends upon the flexibility and time that they are prepared to give for investments to mature.
Warren Buffett, for example, has a lot of patience with his investments and often jokes that certain sectors had a ‘bad decade’, insinuating that things will turn around in the next decade.
Most people are obviously not in the same position as Warren Buffett. However, in some circumstances, it may be more advisable to give an investment more than a year to mature.
These decisions should be well informed though and investor should have a strong reason for keeping hold of the stock.
For instance, the stock of a company may have performed badly if the firm spent a year preparing for the launch of a new product or service. It would be unwise to sell the stock if the company is set to grow significantly in the upcoming year.
Sometimes stocks take time to perform and it’s the job of the investor to do their homework and know if an investment is worth keeping or not.