How Not To Evaluate Your Investments – Forbes

People often ask me about their investment returns. During the height of COVID, some of these conversations involved people hearing on the news that the market was down. They then looked at their statements and saw the same. “Should I do something?” they would ask. Before I answered, I always asked, “What’s making you think about doing something?” These were the most common answers:

·        “The S&P 500”

·        “The change in my account balance since the last time I looked”

·        “The shock of how much I’ve lost”

Comparisons to the S&P 500

Someone I know told me that news of the S&P 500 affected his nerves regarding his portfolio. (The S&P 500 is an index run by Standard & Poor’s that represents the 500 largest U.S. stocks.) I asked him what his portfolio had in it. He did not know. Subsequently, he brought his statements to me, and I noticed that his portfolio was invested 60% in US bonds. The 40% that was in stocks was not all in companies that should be benchmarked against the US S&P 500. Some were companies based in other countries.

Since 60% of this man’s investments were in United States corporate bonds, he should have been comparing that portion of his portfolio to a comparable index, such as the Barclays US Aggregate Bond. In fact, when you look at the fact sheets or disclosure information from mutual funds, they tell you what the mutual fund’s portfolio manager is benchmarking returns against. As I said to him, I have yet to hear on the 6 o’clock news any mention of what the bond index equivalent to the S&P 500 achieved. Ideally, but not always, the bond portion of his portfolio would move in opposition to the stocks. So, when the stocks were down, the bonds would be up and vice versa. (Even with bonds, of course, there’s no one-size-fits-all benchmark. For example, if you’re invested in US government bonds, a better index would be the Barclays US Government TR USD (1973–2018).)

Further, since 20% of his portfolio was in international companies, an international benchmark, such as the MSCI EAFE® Index, would be more representative of international return expectations. (The MSCI EAFE® Index (Morgan Stanley Capital International Europe, Australasia and Far East Index) is composed of more than 1,000 companies representing the stock markets of Europe, Australia, New Zealand, and the Far East and is an unmanaged index. EAFE represents non-U.S. large stocks.)

To really evaluate his portfolio, he would need a blended benchmark reflecting the various asset classes: 60% Barclays US Aggregate Bond + 20% MSCI EAFE® Index + 20% S&P 500 Index.

Changes to your account balance

Another popular way for people to look at their investments is to determine whether they have grown since the last time they looked. Recently I had a situation where someone who found herself working at home due to the coronavirus was looking almost daily. Much of this was inspired by hearing the news of the gyrations of the S&P 500 Index. Tracking shifts in your account balance can be a particularly dangerous way of evaluating returns. If you are regularly adding money to your account by, for example, systematically investing in your 401(k), the balance can go up simply because you added money. That might make you feel better, but it doesn’t tell you anything about how your investments are doing.

The nature of risk in the stock market and, to varying degrees, in the bond market is that things will go up and down, particularly in short-term periods. However, the dips don’t necessarily mean that you’re not advancing toward your goals. Some people, when they saw that the market had gone down, decided not to continue systematically investing in it. Others went in looking to buy. When the market is down, that means you are buying an investment, let’s say a mutual fund, at a lower price than it was selling for previously. That means you’re able to buy more shares for the same amount of money. Assuming the fund goes back to its previous selling price, you have made money on all the shares that you bought when it was priced for less. I call that buying at a discount. Just as it’s nice to find great deals on the clearance rack of your favorite clothing store, discounted stocks can be great finds, too. Clearance doesn’t mean that your purchase is not great fashion—or a great investment.

Losses that exceed your risk tolerance

When investors are shocked by the extent of their losses during a downtown, it may mean their investment approach is out of sync with their risk tolerance. The question of risk tolerance is a tricky one. Some people use words such as “conservative” and “aggressive” to express their risk tolerance. But I’ve learned that some who say “aggressive” actually mean they want higher returns when the market is up, but when the market goes down, they may be more conservative than those who call themselves a “conservative” investor. The so-called “aggressive” investor may even want to sell to cash and wait until the market returns to a roar.

Then, of course, there are those who were defaulted into a retirement investment without being asked about their risk tolerance. Instead, a risk tolerance was chosen for them. The most popular choice is the target-date mutual fund, which changes its risk exposure in stocks as the investor ages. I have found many people who are younger invested in a target-date mutual fund with 90% stock even though their risk comfort suggests they should be invested 90% in bonds. This can easily lead to those investors wanting to go to cash when they see their balance go down dramatically.

I believe it is important to have both a combination of questionnaires about risk tolerance alongside quantified examples of the expected declines that correlate to different risk tolerances. What do terms like moderate, moderate growth, capital appreciation and aggressive mean? These terms usually correlate to a blending of various asset classes such as the one shown in our first example. The ones towards the riskier end of the spectrum have higher allocations or percentages of stocks. Often the information given seems to highlight historical returns with no indication of what the ride was for investors who stayed invested over the last 3, 5 or 10 years.

If your goal is to retire with a certain accumulated balance, you can find a combination of savings and expected returns from a blended benchmark portfolio. And a professional advisor can help you determine your actual risk tolerance and then balance that with the risk you’ll likely need to accept in order to reach your goal.

If news about market downturns rattles you or you see that your investment balance has plunged, take a deep breath. Ask yourself whether the benchmarks you’re using are accurate and whether the plunge really warrants a response. To help you answer those questions and determine whether your investment plan is tailored appropriately for you, I recommend seeking out a fiduciary investment advisor with accredited designations such as certified financial planner, chartered financial analyst or accredited investment fiduciary.

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