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Three Ways to Evaluate Portfolio Performance

Gary Pollock, Wealth Manager, First Republic Investment Management
May 5, 2017

With the S&P 500 climbing nicely in recent months, some clients have asked why their overall portfolio hasn’t performed equally well.

There’s an easy explanation. Most portfolios are not invested 100 percent in U.S. stocks; they are diversified across a range of assets. Bonds, real estate, alternative investments and cash all typically lag when stocks soar. But when stocks eventually retreat — which will happen — those other assets are likely to outperform and a diversified portfolio could very well “beat” the S&P 500.  

This leads to a broader, very important question that clients ask: How do I gauge how well my portfolio is performing?

Common performance measures
When evaluating a portfolio’s performance with clients, investment advisors often look at two common measures:

Relative return
How well did a portfolio stack up to a market benchmark such as the S&P 500 or the Dow Jones Industrial Average? Since most portfolios are diversified, advisors will use a blended benchmark that shows clients how well their portfolio — comprised of, say, 60 percent stocks, 30 percent bonds and 10 percent cash — stacks up to a comparably diversified index.

Investors love to say they “beat the market,” so they naturally want to know their relative return. However, this measure is imperfect as it’s difficult to find a benchmark that can be easily compared to a well-diversified portfolio. What's more, outperforming a benchmark isn’t such a comforting thought in years when markets are lousy. A client whose portfolio value falls 10 percent in a year the S&P is down 20 percent may have a great relative return, but they are still losing money.

Absolute return
The second performance measure that advisors often use is absolute return, which looks at the true return a portfolio generates after costs such as investment fees and taxes. In other words, regardless of how your portfolio compared to the S&P 500 last year, did it at least generate a net positive return? Did you actually make money?

Investors don’t want to lose money, of course, so absolute return can show a client that their portfolio is growing over time.

The better measure: Client-specific returns
Relative and absolute return are both useful in gauging portfolio performance. But they look backward, evaluating how a portfolio did over, say, the past six months or five years.

Our job as advisors is to help clients look forward. What average annual return do you need to generate over the next 10 or 30 years to meet your goals? Are you trying to accumulate enough money to retire securely, or have you already amassed enough and now must preserve that wealth?

That brings us to the most important portfolio performance measure of all: client-specific return which helps determine whether or not the   portfolio is achieving the goals of the client.

To develop a client-specific performance goal, an advisor must first understand the client’s objectives. Take the case of a retired couple that relies on their investments to generate income. Should they aim for S&P 500-beating returns, or should they choose an investment strategy that lets them sleep at night? I often tell clients that, if they’ve already achieved their financial goal, they shouldn’t keep making high-risk investment decisions. Instead, I suggest designing a diversified portfolio that will help them preserve their wealth and grow enough to meet their needs, but not take on too much downside risk.

The same may go for clients who are still working. If they can meet their retirement goal by earning five percent annual return for the next few years, an overly aggressive portfolio could expose them to significant risk. While that client should not necessarily settle for five percent annual growth, their investment team should design a portfolio that stacks the odds in favor of reaching that goal.

A thoughtful approach
Designing an investment portfolio shouldn’t happen in a vacuum. It needs to be guided by an understanding of the client’s short- and long-term goals, as well as their tax situation, cash-flow needs, risk tolerance, gifting desires and estate plans. In the end, what ultimately matters isn’t whether a portfolio keeps up with the S&P 500, but rather that it allows the client to reach their goals — and that’s the best performance target of all.

Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized.

©2017 First Republic Investment Management