As clients of a Registered Investment Advisor (RIA) firm, you understand that one of the primary objectives of investing is to grow your wealth while managing risk. However, when it comes to evaluating the performance of your investments, many factors come into play that can make the process complex. It’s important to recognize that simply looking at the raw returns of your investments isn’t always enough to gauge the success of your strategy. Below, we’ll explore key considerations for evaluating and judging your investment performance in a way that provides a clearer picture of your financial success.
1. Understand Your Investment Goals and Benchmarks
The first step in evaluating your investment performance is to ensure you have clear and specific goals. Investment performance isn’t just about the numbers; it’s about aligning those numbers with your long-term financial objectives. Whether you are saving for retirement, funding a child’s education, or seeking to build generational wealth, each goal requires a tailored approach.
Once your goals are defined, it’s important to establish a benchmark against which to measure performance. A benchmark is a standard or reference point that you compare your investment returns against. A common benchmark could be a market index, such as the S&P 500, but you will likely need something more specific, or even use a blend of several benchmarks depending on your investment strategy. A portfolio targeting a mix of 50% stocks and 50% bonds should probably use a mix of something like 50% S&P 500 returns and 50% Barclays US Aggregate Bond Index as a blended benchmark (rather than just one equity index) to create a fair comparison to judge portfolio returns.
Key Questions to Consider:
- Are your goals short-term, medium-term, or long-term?
- What benchmarks are most relevant to your investment strategy? (e.g., inflation, broad market indices, or sector-specific indices)
2. Focus on Risk-Adjusted Returns
When evaluating investment performance, one of the most important factors to consider is risk. Simply looking at the total return of your investments may give a distorted view if the level of risk taken to achieve that return is not taken into account.
Risk-adjusted return is a way of comparing the return of an investment relative to the amount of risk taken. There are several metrics used to assess risk-adjusted returns, including:
- Sharpe Ratio: This ratio helps you understand how much return you’re receiving for each unit of risk. A higher Sharpe ratio indicates that an investment is providing a good return for the risk it is taking.
- Sortino Ratio: Similar to the Sharpe ratio, the Sortino ratio considers only the downside volatility (the risk of loss), giving a clearer view of how an investment performs in times of market downturns.
- Upside/Downside Capture Ratio: Relative to an index (usually the S&P 500), this metric measures a portfolio’s historical participation in positive and negative returns. A portfolio with a 60% upside and downside capture ratio would be expected to capture 60% of the performance of the index during a bull run, while only participating in 60% of the losses during a market correction.
Evaluating risk-adjusted returns ensures you are not overexposing yourself to unnecessary risk just to chase higher returns.
Key Questions to Consider:
How much risk are you willing to take on to achieve your investment goals?
Are the returns you are seeing worth the level of risk involved?
3. Time Horizon Matters
The time horizon of your investments plays a crucial role in assessing their performance. If you have a long-term investment horizon, short-term fluctuations in the market are less of a concern, and you may be more focused on long-term growth. Conversely, if your investment horizon is shorter, such as in the case of near-term goals like buying a home or funding a child’s education, performance should be evaluated more frequently and with a greater focus on preserving capital.
It’s easy to get caught up in short-term market swings, especially during periods of volatility, but your ability to stick to your investment strategy can have a major impact on performance over time. Evaluating investment performance with respect to your time horizon helps you avoid knee-jerk reactions to temporary market downturns.
Key Questions to Consider:
- What is your investment time horizon for each of your financial goals?
- Are you comfortable with short-term fluctuations if your goals are long-term?
4. Compare Your Portfolio’s Performance to the Broader Market
While benchmarking against a relevant index is essential, it’s equally important to evaluate how your portfolio is performing relative to the broader market. However, this comparison needs to take into account your specific asset allocation and strategy. For instance, a portfolio heavy in bonds will likely underperform a portfolio of high-growth stocks, particularly during a bull market.
Additionally, market conditions vary. While stock markets might be in a bull phase, other asset classes, such as real estate or commodities, might be performing poorly, or vice versa. A balanced portfolio that is diversified across multiple asset classes and geographic regions may not always match the performance of the stock market, but it could provide steadier returns over time, especially during periods of volatility.
Key Questions to Consider:
- How does your portfolio compare to the broader market, given your asset allocation?
- Is your portfolio properly diversified to handle various market conditions?
5. Evaluate Consistency and Long-Term Performance
Lastly, it’s crucial to take a long-term view of your investment performance. Markets will inevitably experience periods of volatility, and even the best-managed portfolios can go through short-term setbacks. Therefore, evaluating consistency over time is more important than focusing on one period of strong or weak performance.
Look at your portfolio’s performance over multiple time frames: 1-year, 3-year, 5-year, and even 10-year periods. This will help you better understand whether your investment strategy is sustainable and aligned with your goals.
Key Questions to Consider:
- Is your investment strategy consistently performing in line with your expectations over the long term?
- How has your portfolio weathered market downturns?
Evaluating and judging your investment performance involves a combination of factors—your goals, benchmarks, risk profile, time horizon, fees, and consistency. By considering these factors thoughtfully, you can better understand how well your investments are working for you. Remember, investing is a long-term journey, and successful investment management involves regularly revisiting your strategy, adjusting as necessary, and maintaining discipline in the face of short-term market fluctuations.
We are here to help guide you through this process. If you have any questions or would like to discuss your current investment strategy, please don’t hesitate to reach out. We’re committed to helping you meet your financial goals and ensuring your investment approach is aligned with your objectives.
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Jake Fromm | Chief Investment Officer, CFS® | It is our mission to help you think differently about your wealth so you can LIVE WELLthy™ today and tomorrow.