How well is your portfolio doing?

E*TRADE from Morgan Stanley


When it comes to your investments, knowing how much you’ve made or lost isn’t the only thing that matters, but it’s definitely pretty high on the list. It would be nice if a quick glance at a simple chart was all you needed, but, in fact, it’s easy to misinterpret your own portfolio’s performance, as well as numbers you see quoted on the news or in investment marketing materials. So we’ve put together this 3-step framework for evaluating your portfolio’s returns—i.e. how much you’ve gained or lost over a given time period.

1. Know how your rate of return is calculated

Your broker, bank, or other financial institution likely provides you with a performance chart or figure to show you how much your investments have gained or lost in a specific time period such as a quarter or year. It’s important to know how they calculate these numbers and what’s included in them.

As an example, let’s say your account starts out with $1,000 at the beginning of the year, you add $100 in the middle of the year, and you end the year with $1,100. Your balance grew by 10% but only because you deposited money, not because your investments gained value. So your rate of return is actually 0%.

Standard return calculations will typically account for:

  • Dividends and interest payments you received (which are investment returns)
  • Deposits and withdrawals you made (which are not investment gains and losses)
  • Fees, commissions, and other costs you may have paid (which reduce your real return)

Most financial institutions calculate performance using the “time-weighted return” method. It accounts for dividends and interest received, and excludes the effect of deposits and withdrawals. You may also encounter an alternative method called “dollar-weighted return” (also known as money-weighted return). You can ask your financial firm or financial advisor what methods they use.

2. Select an appropriate benchmark

Once you understand how your rate of return is calculated, it makes sense to ask if that’s a good return or not. You can do that by comparing your rate of return to benchmarks, typically market indices, which track the performance of groups of selected investments. If you see that the benchmark was up 4% for the year and your account is up 6%, then, congratulations, you did comparatively well.

As you can already guess, it’s important to choose appropriate benchmarks. For example, the Dow Jones Industrial Average is a very well known market index, but if your portfolio isn’t at all similar to the 30 industrial stocks that are in the Dow, it may not offer a particularly useful comparison. If you want to compare your portfolio’s returns to the performance of the broader stock market, something like the S&P 500, which includes 500 large U.S. companies across many industries, might be a better choice. There are thousands of market indices that track a wide range of different types of investments and market segments. It’s also important to remember that one cannot invest directly in an index, they are unmanaged, and don’t include any fees which may be applicable to the investments in your portfolio.

Before you pick a benchmark to compare against, take the time to analyze the investments in your own portfolio. Armed with that information, you can look for benchmarks that consist of investments similar to yours, and you can also look for benchmarks that show you how a significantly different set of investments has performed. Both types of information may help you make decisions about your portfolio.

3. Compare your risk-adjusted performance against your benchmark

Let’s say that you find your portfolio has outperformed your benchmark. This might be a result of your smart investing ideas, in which case you would deserve congratulations again. But what if it’s simply the result of taking on a larger amount of risk?

This is where the idea of “risk-adjusted returns” comes in. Essentially, these are methods for gauging returns on an investment or portfolio that take into account the amount of risk required to achieve the return. Imagine that two different investments each provided a 5% return, but one of the investments was high risk and the other was low risk. Nominally, they have the same return, but using risk-adjusted measurement methods, the low-risk investment would score better—because getting the same return with lower risk is obviously a better investing outcome.

There are many methods of measuring risk-adjusted returns, but one very well-established figure that every investor should know about is called the Sharpe Ratio. A higher Sharpe Ratio indicates a better risk-adjusted return. So, if your portfolio has a higher Sharpe Ratio than the benchmark you outperformed, then maybe it really was your savvy investing that did the trick.

With this 3-step framework, you can make a good start on developing a better understanding of your portfolio’s performance. And that, in turn, can help you feel more confident about your investing and about making decisions in the future.

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