How to measure your investment success

Performance is certainly the “bottom line” on investing. After all, that’s the end result of all your efforts. But successful investing has several facets that are just as important. They will better enable you to understand your performance, put it in perspective and set you on the right course for the future.

Measure results: Producing above market performance is very difficult. Only about one money manager in five can beat market benchmarks net of fees over market cycles of three-to-five years. Keeping score, however, is easy. Yet many people do a poor job of actually identifying their annual returns accurately. Studies show that people tend to overestimate their returns and how they do compared with market benchmarks. Investors often don’t see the forest for the trees. They focus on only a few of their investments and lose sight of how their entire portfolio is performing. If you can’t figure out to one decimal place your investment return net of fees annually, get your financial adviser/money manager/broker to give you this number clearly on one sheet of paper. The reports you get should show the most recent year period and your performance back in time as well, so you will know how you’ve done over the long run.

Compare to benchmarks: Okay, so now you have your performance figures on that sheet of paper. That’s a start, but you need perspective. Is the number good or bad? The only way to know is to compare it to a market benchmark. You need to know if your performance is in the right “neighborhood” or not. For stocks, compare to the Standard & Poor 500 Index, Wilshire 5000 Index or Russell 3000 Index. Performance for these indices is readily available from the internet, libraries and newspapers.
A second way to compare your performance is with mutual fund benchmarks, which are provided by Lipper and Morningstar. Check out their websites.

Understand risk: Two risk measurements are “beta” and “alpha.” Beta measures the amount of a manager’s or portfolio’s return that is attributable to the broad market itself. For example, a stock market benchmark will have a beta of 1.0 and a portfolio of stocks or stock mutual funds will have a beta that is higher or lower. A lower beta means a manager or portfolio has had less volatility (or risk) than the broad market. Alpha measures the amount of a manager’s or portfolio’s return that is attributable to the manager. It tells you if a manager is good at picking stocks or bonds and is adding to the return above whatever return is coming from the broad market itself. It identifies if the manager is skillful or just lucky. The more positive the alpha, the more skill a manager has demonstrated.

Set realistic expectations: Once you’ve accurately measured your results and portfolio risks and benchmarked them, your next step should be to revisit your expectations. Realistic investment return expectations are critical to you long term. Some experts believe stocks will do 6% to 9% annually and bonds 4% to 5% annually. Inflation will erode purchasing power at a rate of 2% to 3% per year. However, nobody can say for sure what will happen.

There’s much more to successful investing than performance alone. For the best route to achieve your financial goals, measure your returns and risk accurately and regularly, benchmark them for perspective and focus on realistic expectations for what the future has in store.