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Investing isn’t a competition. The idea is to generate the returns that you need to meet your investment objectives, all while staying within your chosen risk tolerance. But it’s helpful to compare the returns you’re earning versus certain benchmarks to ensure that you’re doing as well as you can. If you’re taking on lots of risk with your portfolio but only earning the same amount you could get in an insured CD, for example, then you probably want to make some adjustments to your asset allocation.
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There are many methods you can use to determine just how well your portfolio is doing. Which one is most appropriate for you will depend on the type of portfolio you’re trying to achieve. Here’s a look at some common ways to evaluate just how well — or how poorly — your investment portfolio is doing.
Benchmark Returns
One of the easiest and most popular ways to track portfolio performance is to use appropriate benchmarks. For an all-stock portfolio, one of the most common yardsticks is the S&P 500 index. This index of the largest companies in the U.S. market is commonly used in the financial press as a representation of the stock market as a whole. In fact, if you ask any financial professional how “the market” is doing, the return of the S&P 500 index will often be the quoted benchmark.
But the S&P 500 is not the only benchmark you can use. If your portfolio consists exclusively of foreign stocks, for example, a more appropriate benchmark might be the MSCI EAFE, which tracks stock returns in Europe, Australasia and the Far East. A bond portfolio might be best matched up against the Barclays Capital U.S. Aggregate Bond Index, for example. Depending on the type of portfolio you have, choosing an appropriate index as a benchmark is a good way to measure your performance.
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Absolute Returns
While it’s good to have a benchmark to compare returns to, some investors only care about absolute returns, not relative returns. If the S&P 500 index is down 35% but your portfolio is “only” down 30%, for example, your outperformance relative to the index might not matter all that much. Another way to measure how well you are doing is by measuring simply what your total net gain or loss is. If you’re a more conservative investor, you might be much happier with a portfolio that returns 5% per year no matter what, even if the S&P 500 index happens to be up 30% in one of those years. Avoiding those big down years by earning 5% instead of losing 35% is of greater concern to some investors, even if it means missing out on some of the upside.
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Goal-Relative Returns
One way to measure your returns is by setting your own investment goal. Regardless of what the market is doing or what the absolute return of your investments is, as long as you can earn enough to reach your goal, you’re doing well.
Imagine that you are saving for retirement and that you want a $1 million nest egg in 40 years. If you are starting with a $200,000 investment, then you’ll need just over a 4% return to reach that goal. And if that is your goal, and you reach it, no other metric as to whether or not you are “doing well” really matters.
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After-Inflation Returns
The returns you see publicized in the financial press aren’t the whole story when it comes to investments. Inflation eats away at absolute investment returns, especially over time.
Let’s say you generate a 5% return from a fixed-income investment, like a bond. If inflation is at 2%, your net after-inflation return is just 3%. This is why many investors prefer the stock market, as it has historically posted good after-inflation returns. If you’re investing in a savings account that pays the national average rate of just 0.04%, once you deduct the current inflation rate of 0.6%, you actually have a negative return. One way to measure your investment success is to make sure that you are posting positive returns after the effects of inflation.
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After-Tax Returns
Taxes are another enemy of investment returns, and they should be considered when evaluating how well you’re doing. After all, an important part of investing is what you actually end up with in your pocket. Although you may post strong absolute returns in your portfolio, if you lose the bulk of those gains to taxes, you’re not as well off as you may think. This is why it’s imperative to generate long-term capital gains wherever possible, as opposed to short-term gains. Whereas short-term gains are taxed at your ordinary income tax rate, long-term gains have a special tax rate that can be as low as 0%, depending on your tax bracket.
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