Is Your Portfolio Performance As Good As It Seems?
When you check your investment accounts and see positive growth, it’s easy to assume your assets are reaping good returns. The untrained eye may not understand the true measures of portfolio performance, and nominal returns are far from an accurate indicator. Professionals assess portfolio performance using a collection of measures, including interest rates, yields, gains and much more.
The problem many untrained investors have is that they either don’t compare their investment returns to a benchmark, or they compare “apples to oranges,” leading them to a misguided conclusion about their portfolio's performance.
In order to properly evaluate your investments’ performance, you need to know what to measure, but also with what you should compare these returns. If you own a collection of stocks – which come with relatively higher expected risk and return – comparing their returns to that of Treasury bonds can easily lead you to come to an incorrect conclusion. Treasury bonds are considered a very low-risk investment, which means they also come with lower expected returns. These bonds simply serve the same purpose in your overall portfolio.
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A more suitable comparison would require you to measure your stock’s performance to similar investments – perhaps an index of similar stocks in your portfolio. Let’s take a dive into the different measures you can use to assess your portfolio performance.
Rate of Return
The rate of return on your portfolio is largely considered one of the simplest and accurate measures of portfolio performance. It is simply the percent change of your total portfolio value from your initial investment(s). This covers all capital gains, interest, stock dividends and coupon payments from bonds.
The simplest way to calculate your portfolio’s rate of return is to first subtract the total amount of money you’ve invested in from your portfolio’s total value, then divide that figure by that same number you’ve invested. Below is an example. Let’s say you initially invested $100,000 in your portfolio, and over the past five years, invested $10,000 each year, totalling $50,000 on top of your initial investment. The sum total of your investment is $150,000. If your portfolio value sits at $165,000 today, it’s rate of return is 10%:
- $165,000 - $150,000 = $15,000
- $15,000 ÷ $150,000 = 0.1 or 10%
While your portfolio's rate of return is a good starting point, it’s important that you also determine your investments’ yield. While return measures historical performance, yield is comparatively a forward-looking measurement.
Yield takes interest and dividends into account, while ignoring capital gains (the growth or decline of a stock’s market price, for example). It is an annual percentage that assumes your assets’ interest and dividends will continue to pay out at the same rate in the future.
Your assets’ yield also accounts for its level risk – a key barometer for the true performance of your investments. Fundamentally, the higher risk you take on, the higher your potential yield may be. As mentioned, stocks are generally higher-risk investments than bonds.
To calculate a stock's yield, total the dividends collected over the year and divide that number by the stock's current market price. Dividends are simply a percentage of a company’s earnings that it chooses to pay out to its shareholders. Many growth stocks do not pay dividends, however, instead investing that money back into the company to help it grow. If a company does not pay dividends, then it has no yield, generating its gains from growth in its stock price.
Calculating a bond’s yield is a bit more complicated. Companies issue bonds to borrow money from the public in order to fund its endeavors. When you buy a bond “at issue” – when it’s first listed on the open market – its yield is simply the posted interest rate on the bond, known as its coupon rate.
Bonds are typically offered at $1,000 each, it’s par value. The coupon payments are the business’ cost to borrow your money, just as a bank charges an interest rate when you take out a loan. The rate of return on a bond is determined by dividing its annual coupon payments by your initial investment – the par value of $1,000 (per bond). If you will collect $75 in coupon payments over the year, the initial yield on that bond is 7.5%.
However, a bond’s yield fluctuates after issue as interest rates change in the market and the issuing company’s financial health changes. Bonds can be bought and sold after issue in the secondary market, just like stocks. Its current yield depends on the price of the bond at that point in time, which is hardly the same $1,000 par value.
Because the coupon payments remain the same throughout the life of a bond, a lower-priced bond should potentially return a greater yield. Take the example above: If you expect to collect $75 in coupon payments over the year, but after issue, the bond only costs $900 on the secondary market, its yield is 8.33%. This differs from a bond’s yield to maturity, however, which you can read about here.
Calculating a conventional CD’s yield is far simpler than a bond’s yield because their isn’t a secondary market for these instruments. Your CD pays a specific interest rate, which, when annualized, is its yield. Your financial institution will often calculate these figures for you.
Capital Gains and Losses
We’ve made mention of capital gains, commonly associated with stocks or mutual funds. These are the returns from an investment’s change in market price. If you sell a stock for $80 that you initially purchased for $75, you earned capital gains of $5 per share, or 6.66%.
Capital gains are a taxable income, however. So the true return on these assets may not actually be the rate you calculate. If you buy and sell a security within a year, it will be taxed as a short-term capital gain – the same rate as your ordinary income. If, however you hold an asset for more than a year, it receives a long-term capital gains tax, which is lower than the rate deducted from your ordinary income.
Of course, if you house your assets in a retirement account, your capital gains may be tax free.
Other Significant Factors
As much as taxes play a big role in the true performance of your portfolio, risk and inflation also have a significant impact.
There are several measures for risk-adjusted return that take into consideration the return on a security relative to its risk, including the Sharpe and Treynor ratios. If, for example Asset A and Asset B earn the same return over a given time period, but Asset A bore less risk, it has a greater risk-adjusted return.
An inflation-adjusted rate is considered the real return on an investment. It compares the performance of your portfolio to the simple rise in inflation over the same time period. For example, if your portfolio grew 6% last year, and inflation rose 3%, your true spending power only grew 3%, because the cost of goods and services have risen by 3%.
Determining Your Portfolio's Success
As you might have concluded, determining whether your portfolio is performing well is complex. It may be a very difficult task on your own, which is why it’s always a good idea to work with a professional to measure your portfolio’s performance and assess any areas of weakness.
If you’d like a second opinion on your portfolio, you can schedule a simple discussion with a wealth advisor. Just click the button below to get the guidance you’re looking for.
About Greg Hammond, CFP®, CPA
Greg Hammond is the chief executive officer of Hammond Iles Wealth Advisors, and co-founder of Planned Giving Strategies®. Greg leads a team of professional financial advisors providing customized wealth management and investment solutions for high-net-worth individuals, families, companies, and charitable organizations across the U.S.