Evaluating Investment Performance


It’s only natural that investors are keenly focused on the returns of their portfolio. Everyone wants to know how they’re doing, and how much their portfolio is appreciating. Before the days of 24-hour news, smart phone apps and websites providing minute-by-minute market news, investors were satisfied seeing positive long-term returns.

The proliferation of benchmark reports, indexes and the constant comparison of the performance of portfolio managers have made it more complicated for investors to determine how to best evaluate their returns in relation to the overall market. The challenge is that a comparative performance evaluation, for the typical investor who has a diversified portfolio, is not a simple matter.

The first hurdle is selecting a benchmark that adequately reflects the holdings in a portfolio. A portfolio with large U.S. companies could use the S&P 500 as a benchmark, but what if the holdings also included some bonds, or international equity? In most cases, a number of benchmarks should be used to accurately compare and evaluate performance.

To further complicate matters, a thorough performance evaluation should also include an analysis of risk relative to the benchmark. Underperforming, compared to an index, is OK for a period of time, if the risk in the portfolio was commensurately lower than the index. A thorough and accurate performance evaluation should include measures of risk and risk adjusted return, which is a process that most individual investors do not have the background, or tools necessary to perform. So what’s an individual investor to do if they want a simple yardstick, and how do they figure out if they are doing well? There are a couple of methods to simplify this analysis and avoid the pitfall of over simplification, which can lead to incorrect conclusions. 

If expectations are reasonable, setting a target long-term rate of return is probably the simplest approach to performance evaluation. A financial professional should be able to help you build a portfolio around your target rate of return, provided it is realistic. This makes analysis simple, is the portfolio above or below the target. Keep in mind that it is a long-term average target. Be prepared for periods of over and under performance. A second option is to determine what the benchmark is going to be before funds are invested. Select a benchmark or set of benchmarks that closely reflect the portfolio. Keep in mind, that as objectives change, so should the benchmarks.

Going beyond these fairly simple approaches, individual investors that want to dig deeper, are probably best served by having a discussion with their financial professional. Investors should expect to be provided with information including recommended benchmarks, and how they are blended to create an apples-to-apples comparison.

A discussion of performance evaluation cannot be complete without a discussion of evaluation frequency. Long-term investors should be focused on performance measured in years. A common pitfall is for a long-term investor to be shaken by a bad month or quarter, and react by making ill-advised changes in the management of their portfolio.

The essence of performance evaluation; avoid oversimplification, set realistic expectations and stay disciplined. If something looks problematic, dig a little deeper before making any changes.