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23

Jul

How is Your Investment Performance?

Published -
July 23, 2023

This is a question that can be on the minds of investors.

This is a question that may be discussed between friends.

This is a question that financial salespeople love to ask prospective clients.

This is a question that can be harmful to investment performance, especially without a good understanding of what drives investment returns in the short and long term.

In our office, we don’t spend much time talking about investment performance with clients. The irony is that the way we approach investment management, the odds are that our client’s portfolios will be in the top percentiles for performance over time.

We take investment management very seriously and understand the importance of strong returns. We know we are good at managing money and understand what factors and portfolio characteristics lead to impressive investment returns. We also understand that poor investment performance can reveal underlying portfolio construction or management issues.

The reason we do not spend much time reviewing past performance with clients is that we like to focus discussions on factors that enhance the likelihood of achieving long-term goals. We look forward rather than focusing on the recent past. Our primary objective is to provide our clients with peace of mind and clarity around meeting their financial goals. We prioritize strategies that foster sustainable long-term outcomes—including investments and financial planning.

So, the important question is, “Is my portfolio structured and managed for optimal growth going forward?”

What Drives Investment Performance?

As previously acknowledged, investments indeed hold significant importance in ensuring financial sustainability. However, it is crucial to focus on the investment process itself, particularly the factors that contribute to robust long-term performance. Here are the key elements that lead to such favorable outcomes:

Broad global diversification. This is the old “don’t put all of your eggs in one basket” adage. Being diversified throughout different asset classes is the first step to building an efficient portfolio. Diversification has been called the one free lunch in investing.

Being diversified also means the avoidance of any concentrated positions which add uncompensated risk—where the investor receives no additional expected return but takes on additional risk. Not a good trade-off.

Minimizing investment costs. Investment costs can take a healthy bite out of investor returns. These costs and fees take many forms such as fund expense ratios, commissions, loads, 12b-1 fees, bid-ask spreads, excessive turnover (trading), not to mention the additional list of fees associated with any insurance or annuity-based products.

Minimizing taxes. This complex area can return significant savings if done correctly. We have seen situations where clients can save hundreds of thousands of dollars in taxes over their lifetime with proper planning.

Management of different risk factors. Risk comes in many shapes and sizes and having a grasp of the multiple forms is important. Some risk factors should be accepted, others avoided, some embraced, and most managed to the investors’ advantage. Risk and return ARE related, and investors should never expect outpaced returns without additional, and often understated risk.

Intelligent rebalancing. We call this “dynamic rebalancing” and what we mean is that the act of rebalancing should be active and thoughtful. Done correctly, rebalancing through dividend and interest payments can increase returns in otherwise volatile or down markets by continuously buying into those asset classes that are lagging. A thoughtful aspect of dynamic rebalancing is not automatically reinvesting dividends in mutual funds and ETFs, which can lead to buying more overpriced assets at inflated prices.

Keeping emotions in check. The importance of being disciplined cannot be overstated. This is often the difference between accepting short-term discomfort or doing the wrong thing at the wrong time for some temporary relief.

Comparing Your Portfolio to Someone Else’s

Without a good understanding of what is inside someone else’s portfolio, making a comparison can be very misleading—and potentially harmful.

Let’s look at an example of three different portfolios—one we’ll call the efficient portfolio (A) and the others inefficient portfolios (B and C).

Portfolio Returns

Low*       Expected High*

Efficient Portfolio A -3.0% 7.0% 17.0%

Inefficient Portfolio B -7.0% 5.5% 18.0%

Inefficient Portfolio C -23.0% 5.0% 33.0%

*Within one standard deviation or about two-thirds of the time

The efficient portfolio has incorporated all the factors we outlined above. The inefficient portfolios suffer from expensive investment products, excessive trading and lack diversification.

During any short period of time, whether it is one quarter or three years, the inefficient portfolios can have better performance than the efficient portfolio. This, however, does not make them better or more attractive going forward.

If you are in portfolio A and your portfolio grew 3% last year and your friend is in portfolio B and his grew 5%, you are still in a better position for long-term growth with lower volatility. Over time these portfolios will converge toward their expected returns and portfolio A should significantly outpace portfolio B.

Compounding this confusion is that it can be difficult to determine which portfolios are efficient or inefficient without a close look at the composition of the portfolio. This is not easy to the naked eye.

Let’s look at the harmful part of comparing portfolios using only past performance: If you believe your portfolio A isn’t doing well and decide to make a change, you may be tempted to move to portfolio B or C because they performed better in the recent past. Without understanding the drivers of returns, you could fall into the performance chasing trap. This trap is why most investors never come close to meeting market returns.

The Bottom Line

The composition of a portfolio and how it is managed is more important than how well it performed last month or last year. Because we are confident about the composition and management of the portfolios we build, and how they will perform in the long-term, we don’t fret over short-term performance.

Understanding the drivers and detractors of investment returns can give investors a higher level of emotional intelligence when it comes to their investments, leading to lower levels of financial stress and the elimination of detrimental performance chasing behavior.

Happy investing!

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