Crunching the Numbers

When your financial advisor tells you how your portfolio is doing, you don’t have to take his word for it.

 

 

By Jack Waymire

www.InvestorWatchdog.com

If you’re like most people, your perception of your investment performance is based on reports and commentary from your financial advisor. But financial professionals have a major conflict of interest: They know that poor performance may cause you to fire them.

This column describes some of the key factors that affect the performance of your assets. The more you know about these factors, the better you’ll understand how your portfolio is really doing.

Absolute Returns

Most financial advisors show absolute returns when they report investment performance to their clients. Absolute returns are also gross returns, which can be very misleading. Due to fees and tax consequences, your actual rate of return may be substantially lower.

Net Returns

A more meaningful performance number is your net return after all advisory fees, money management fees, custodial fees and transaction charges. A 10 percent return can easily be reduced to a 7 percent or 8 percent return. You should require your advisor to report the net performance of your investments.

After-Tax Returns

Taxes also impact the net performance of assets that are held in taxable accounts. Many advisors use a strategy they call “tax efficient investing” to minimize the taxes you pay for capital gains, dividends and interest. However, like investment expenses, every dollar of tax you pay is one less dollar you have for reinvestment and future use. Your financial advisor and/or CPA should produce a quarterly report that documents the amount of tax you incurred from trading and receipt of income. Then deduct the tax amount from your absolute return to determine your after-tax return.

Real Returns

If your assets have long investment horizons—retirement, for example—you should view “real returns” after inflation has been deducted. Although inflation has been low in recent years, it does erode the purchasing power of your assets, and the longer your horizon the greater the impact.

Risk-Adjusted Returns

More sophisticated investors should also want performance data that is adjusted for risk exposure. A simple technique is to deduct the performance of T-bills, about as close to a risk-free return as you can get, from your absolute returns. A risk-adjusted return is the net return you earned minus the risk-free return, giving you a clearer indication of how much value your advisor is adding.

Contributions and Distributions

Contributions occur when you add assets to your accounts; distributions occur when you take money out of your accounts. Make sure your advisor uses a time-weighted calculation for measuring investment performance. This calculation evens out the impact of positive and negative cash flow in your accounts.

Risk Tolerance

Based on the long-term history of the financial markets, to earn a consistent return of 10 percent or higher, you’d have to invest 100 percent of your assets in the equity markets. This risk exposure may be appropriate for investors under the age of 50 because they should have more time to recover from bad performance years. But investors over 50 have less time to recover. Your return expectations should be consistent with your tolerance for risk.

Relative Returns

I said that absolute returns can be deceiving. Here’s another example: Say your all-equity portfolio earned a 10 percent return—but the stock market is up 20 percent. Instead of being happy with your absolute return, you’re disappointed with your relative return because you lagged the market by 50 percent.

Benchmarks

Most investors use a benchmark to measure their relative performance—the S&P 500, frequently. But this benchmark is only applicable if your assets are entirely invested in large cap stocks like those that make up the S&P 500. If, like most investors, you have a diversified portfolio of stocks, bonds and other investments, you need a more sophisticated benchmark that includes the performance of multiple asset classes. (You can find free independent benchmarks on my website, InvestorWatchdog.com.)

Curator