Measure Investment Performance
There’s an old adage that says, “You can’t manage what you don’t measure.” By the same token, you can’t expect to be a successful investor unless you have a system for measuring key factors every step of the way.
In Part 1 and Part 2 of our series on the 5 Habits of Savvy Investors, we discussed several elements investors can and should measure; including investment criteria, asset allocation, diversification, and risk.
Savvy investors know what should be measured, how often it should be measured, and what tool is appropriate for determining results.
Establish Benchmarks to Measure Investment Success
The benchmarks you establish will let you know whether or not your strategy is working, and to what degree. Many investors and investment companies compare the success of their portfolio against indexes and average.
So then, if your investment portfolio is similar to the S&P 500 or the Dow Jones Industrial Average, use it as a benchmark. Just keep in mind that benchmarks are not a one-size-fits-all tool.
They should be tailored to your specific strategy because the ultimate goal is to measure your success in meeting your unique set of goals and objectives, as discussed in Part 1 of this series.
Common Tools of Measurement
There are some general measurements you can use to start with. Ask yourself the following fundamental questions to measure investment success:
- Have I preserved capital?
- Am I making a profit?
- How does my performance compare to the overall market?
Certainly, these broad evaluations are effective, but let’s drill down on the two most common ways to measure investment performance; which include yield and return.
Simply said, return, or ‘total return,’ is all of the money you make or lose on an investment over a specific period of time – usually, annually. It’s expressed as a percentage of the investment’s cost. It includes interest, dividends, distributions, and unrealized gains or losses (an increase or decrease in the share price) you’ve received from the investment over the specific period of time being measured. Return is a measurement of the total change in value of your investment.
Yield measures the cash flow or income (dividends or interest) an investment generates during a specific period of time – usually, annually. Yield does not include unrealized gains or losses.
To determine whether yield or return is the appropriate measure of your success, you must consider what role a particular investment plays in your portfolio. In other words, you must know not only what you’re buying, but why you’re buying it.
Let’s Illustrate the Importance of ‘Why’
Let’s say, for example, you and your buddy both invest in stocks. His method is to hold them until he can sell them at a profit – which describes the capital appreciation method. On the other hand, you buy stocks to use them to generate cash flow – which describes the income method.
In this scenario, return would be the appropriate performance measure for your buddy, and yield would be better for you.
However, both of you will do well in asking yourselves the 3 questions presented above.
Investing, like any other activity, has both a perceived and actual value. In other words, you may feel like a savvy investor for investing in the hot, new, darling stock of Wall Street. You may perceive, emotionally, that you’ve made a sound investment that’s achieving your desired objective.
But it’s not until you measure this stock’s performance that you gain an accurate, realistic picture of its value in helping you achieve your goals.
Hopefully, you see that if you fail to measure the appropriate results with the appropriate tool, you risk drawing the wrong conclusions; which could lead to costly or even devastating mistakes.
That’s why knowing your unique investment objective and goals, setting realistic expectations of the investment product you think will help you achieve your goals, and finally, tracking its performance with the appropriate measurement tool(s), is critical to your long-term success as a savvy investor.
To learn more about this topic, read this insightful article by Finra: http://www.finra.org/investors/evaluating-investment-performance