Portfolio management–why measure performance?

Two reasons to measure performance

There are two general reasons why it’s essential for any investor to periodically and methodically measure investment performance:

–to protect and build your financial assets, and

–to develop your skills in making investment judgments.

These reasons hold whether you decide to manage your money directly or elect to hire a financial planner of some type to help you with the process.

Using a financial planner

Let’s start with the financial planner case.  A typical arrangement will entail your agreeing to pay the planner a percentage of the assets under management in return for his/her advice.

This type of arrangement is sometimes called a “wrap fee” account.  The percentage can vary, but in my experience it usually ranges from 1.5%-2.0% of assets.

Until relatively recently, when government scrutiny of these arrangements forced changes, even assets held in money market funds were subject to the full fee.  Today, it’s common to have a lower fee apply to cash or bond assets.  (The planner will typically receive other compensation that is rarely, if ever, mentioned. For example, the planner will receive a “12b1” fee of .2%-.3% of assets per year from the mutual fund companies whose offerings the planner’s clients hold.  A fund company  may also pay food, transportation and lodging expenses for the planner to attend educational seminars held at posh resorts.  This can happen if the planner is a very successful asset gatherer or if he reaches a threshold level of client ownership of the fund company’s products.)

What a hypothetical investor pays a planner

Taking our hypothetical investor with $1 million in equity assets, the yearly fees paid to a financial advisor will be on the order of $25,000.  That’s a new car, a wedding, college tuition at any state university, several lavish vacations–or the carrying costs of a vacation home.  I could go on, but you get my point.  This is serious money.

You owe it to yourself to find out what, if anything, you’re getting for this outlay.

Hopefully, you and your advisor have an investment plan based on your financial circumstances that includes a section on how performance will be assessed.  For equities, the most common benchmark would be the S&P 500, although you may have risk preferences or other considerations that dictate a different benchmark.  You also know the price of the alternative.  You can buy an S&P index fund from a provider like Vanguard that tracks the S&P very closely and costs, depending on the asset size, from .09%-.18% of the assets per year.

For most people, the simplest question is whether you’re better off with your planner or with a Vanguard account.  In concrete terms, this translates into:  are you getting the S&P 500 return (total return, i.e., including dividends and not just capital changes) + enough outperformance to cover the fees you’re paying + some extra return to compensate for having an equity allocation that differs from the S&P 500.  (Another note:  sometimes in their reports to you, financial advisors talk about gross returns, i.e. returns before fees.  Those are nice, but you’re really interested in net returns, or returns after fees.)

Obviously, if your planner-constructed equity holdings are outperforming by a greater amount than the fees you’re paying, you’re in great shape.  If on the other hand, you find you’re paying your planner $25,000 a year to lose $25,000 vs. the index for you,  you at least know that you have a problem you need to fix.

Doing it yourself

Everything I said about measuring performance to evaluate the planner you have hired is equally true if you are in effect hiring yourself to manage your money.  Three differences, though:

1.  You are substituting your own time and effort for the money you you’d pay a third party, so you probably should actually put time and effort into the task.

2.  What counts as success is reduced by the fees you would pay to a planner–and one option is just to “opt out” of active management and put all your equity money into an index fund.  This is no fun, in my opinion, but may be the best choice for many people.

3.  You’re highly unlikely to fire yourself.

Your goals in measuring your own performance

As in the case of having a financial planner, measuring performance periodically shows you how you’re doing.  But it also has several additional benefits:

1.  It helps to develop a critical mindset, by encouraging you to think of the portfolio as a whole and the contribution each decision makes to total return.

2.  It helps to thicken your skin, by forcing you to deal with your mistakes.  Even for professionals, this is a very humbling business, because at least 40% of what you do will end up being wrong.  A large part of successful management is recognizing mistakes early and dealing with them

3.  It forces you to look at everything in your portfolio. Everyone, even professionals, has a corner of their portfolio where all the horrible mistakes go to hide, be forgotten about, and worsen.  Yes, this is childish behavior, but it always happens–and you have to have routines like periodic measurement, that force the light of day onto even the most stupid things you’ve done.

4. It allows you, over time, to see patterns in the good decisions and in the mistakes you make, and adjust your behavior.  You can see if you are better with growth stocks or value stocks, whether you tend to try to sell too early or whether you wait too long to admit to and eliminate mistakes.  You’ll find out what position sizes you feel most comfortable with.  Once you begin to study your decision-making in an objective way, you will probably find that you make significant progress in making higher-quality decisions.

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