How To Evaluate Your Investment Performance

How do you know if your investments are performing well? One obvious measure is if you are making money. After all that’s why you invested in the first place. But there are other factors to consider. 

Are they performing as well as other investment options? Are your gains consistent year over year? What if your investments are down? Could you have done something different? What is a reasonable expected return?

If you’re investing, whether it’s in your 401(k), individual retirement account (IRA), 529 Plan, brokerage account or any other type, it’s important to evaluate your investment’s performance. Don’t worry — you don’t have to do this every single day! However, it’s smart to look at your investments at least on an annual basis. 

If you are picking your own stocks you need to conduct an honest evaluation on how you’re doing. You might find that it’s time to work with a professional advisor or invest in mutual funds. And If you’re already invested in mutual funds, you might find that they are not performing as they should. Most importantly, you need to see if you are on track to meet your financial goals.

So how do you evaluate your investments? Is it enough to just look at the percentage of return?

Here are important factors to consider when you evaluate your investments.

Have separate accounts for each of your financial goals

Every financial goal should have its own account. Each goal has its own time horizon and risk tolerance level. Thus each goal will have its own investment plan and asset allocation. For example, money for a down payment on a house, an emergency fund or any short term goal should be in risk free assets such as cash, money markets, savings accounts, certificate of deposits (CDs), or U.S treasuries. The priority for these goals are to preserve cash, not a return on investment. Therefore, investment performance does not matter.

Other goals such as retirement, higher education, wealth accumulation, and speculation will be invested in riskier assets such stocks. For these goals, investment performance does matter. How well these investments do can make a difference if you meet your financial goal or not. And to be able to assess if you’re on track to meet your individual goals, assets need to be segregated.

Evaluate all the investments in the account as a whole

When you review your investments, look at how the account performed as a whole. 

Of course it’s important to evaluate the performance of your individual investments (stocks, bonds, mutual funds, ETFs, etc.) because you need to decide if you still want to hold them. But you can’t judge how well you’re doing by focusing on just a few stocks or just one fund. 

I’ve encountered many people who have been very proud of some of their stock picks. But how have the other stocks performed? Having some big winners does not automatically equal investment success. You need to consider how all the investments are performing. It’s even OK if there are some underperforming assets, as long as you have a diversified portfolio. It’s all the investments in the account that are going towards your financial goal.

Take a close look at your annual returns over time

There are many ways to evaluate investment returns, which can  include capital appreciation, dividends, interest, and return of capital. The annual return, also known as the annualized return, is the most common measure of investment performance. It calculates the average annual return over a specified period of time if compounded. It makes it easier to compare returns to other investments and benchmarks.

Many investments, especially stocks, are volatile and returns vary each year. Some years may have had positive returns, while others years may have been negative. Solely looking at the annual return of one year does not provide you enough information about how an investment performed over time. For example, a stock or mutual fund may have provided a positive return of 20% last year. But in previous years it may have been down 10%. So It’s important to look at the annual returns over multiple years.

Annualized returns provide information on how an investment has performed over time. It tells us what the average annual return would have been if you held the investment through the ups and downs for multiple years. It can be calculated for any time period (two, three, five, 10, 15, 20 years, or even longer). And the calculation includes compounding. It assumes that any distributions (dividends, interest) are reinvested.

Check out this example

Let’s walk through an example to get a better understanding. Before we calculate the annualized return we first need to calculate the holding period return and the holding period rate of return.

Let’s say you invested $1,000 in a mutual fund and held the investment for 10 years. During that time, it appreciated to $1,500. And during that time you received $300 in dividends. So the final value is $1,800.

The holding period return is the total return received from the investment minus the initial value. In our example the holding period return is $800 ($1,800 – $1,000).

Holding Period Return  = (Final Value – Initial Value)

The holding period rate of return converts the holding period return to a percentage. The holding period rate of return is 80% ($800/$1,000 = .80)

Holding Period Rate of Return  = Holding Period Return/Initial investment

Now we can calculate the annualized return over the 10 year period using the following formula.

Annualized Return = (1 + percent return) ^ (1/number of years) -1

The annualized return is 6.08% (Annualized return  = (1 + 80) ^ (1/10) -1 = 6.08%. This tells us that if we held the investment for the 10 year period, the average return per year would have been 6.08%.

Don’t worry, you don’t have to do the calculations yourself. Investment performance information is readily available and there are plenty of online calculators that will calculate the annualized return for you.

You can find mutual fund and exchange traded funds (ETFs) performance information in their prospectus and in numerous third party reports.  If you have a 401(k), the plan sponsor will have performance information on the investments offered in the plan along with your account’s performance data. If you have a brokerage account, see what they offer. Many financial firms have tools available to analyze your account’s performance.

Compare your investment’s return to a benchmark

Comparing your investment’s return to a benchmark is a great way to see how your investments are performing. 

There are many stock market indexes to use as a comparison. The most common are the Dow Jones Industrial Average (DJIA), Standard & Poor’s 500 Index (S&P 500), Nasdaq Composite Index, and the Russell 2000. These are all broad based U.S. stock indexes, but there are many more. There are indexes that measure specific industries and sectors, foreign stocks, bonds, and commodities.

You need to choose an index that closely resembles your investments. If your investments are composed of large U.S companies, the Dow Jones Industrial Average (DJIA) or Standard & Poor’s 500 Index (S&P 500) would be appropriate. When invested primarily in tech stocks, the Nasdaq Composite index or Nasdaq 100 would make sense. If you have foreign stocks, you’ll want to compare them to the appropriate foreign stock index such as the FTSE100, Nikkei, or Hang Sen.

Consider risk free rates

Investing in the stock market and other asset classes such as commodities involve risk. And as an investor, you’re going to want to be rewarded for taking on that risk. Are your investments providing a better return than other risk free assets?

You can compare your return to risk free assets such as U.S Treasuries, saving accounts, certificates of deposit (CDs), and money markets. (It’s hard to believe, but I remember when savings accounts and money markets had an annual percentage rate of 5% or more). 

In order to be rewarded for the risk you are taking, the return of your riskier assets need to exceed what you can get from investing in risk free assets.

Do your returns beat the rate of inflation?

If you’re investing for the long run, your returns need to beat the rate of inflation. If not, you will lose money. (Not in the dollar amount, but in value.) 

For example, if inflation were to average 3% a year, your rate of return will need to be at least 3% just to break even. Your real rate of return is what exceeds the rate of inflation. The U.S. Bureau of Labor Statistics publishes the consumer price index (CPI) monthly which is a measure of inflation.

Key takeaways

When you review your investments, it’s important to have realistic expectations. Financial markets are volatile and unpredictable, especially the stock market. Here are three key things to member.

  1. Don’t try to time the market. No one has a crystal ball and knows what the markets are going to do. Stick to having the right assets allocation.
  1. Don’t expect your investment to have positive returns every year. There will be years where you will see above average returns. But there will also be years where your investments will show a loss. Look at your annualized returns and compare them to the appropriate indexes.
  1. Past performance is no guarantee of future performance. We can look at the annualized returns of our investments and the financial markets, but annualized returns only provide historical information. They do not predict the future.

The ultimate measure of your success is if you are on track to meet your financial objectives.

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