What are the keys to a successful investment portfolio review?
Depending on your investment skills and experience, you can assess portfolios via a multitude of factors. But for most investors, there are some basics that should always be reviewed.
We have covered them in previous posts, but I shall provide a quick summary here.
Pre-Determined Benchmarks
You should always create benchmarks against which you will compare your portfolio composition and results.
Determine relevant benchmarks, using multiple benchmarks whenever possible, prior to actually building your portfolio. At the same time you determine your target asset allocation and investments. This will keep you honest when conducting your portfolio analysis on the actual allocations and performance over time.
As such, benchmarks should be based on your unique Investor Profile and the resulting target asset allocation.
Benchmarks can relate to many different areas. These include: common data or arbitrary numbers; relevant publicly available indices; actual peer and style category performance; planned target asset allocation. For better analysis, use combinations of these benchmarks that best fit your analytical needs.
Performance
Net performance drives wealth accumulation. So you want to make sure your portfolio does well relative to its benchmarks. But performance comes in many different forms.
Performance may be annualized or cover the holding period. A 100% return may sound great. But if it takes place over a 20 year holding period, the annual return may not be as nice as it appears.
Conversely, a 5% annual return may be nice if your peer group average was -10%.
Not all investment returns are the same. Understand the difference between: gross and net returns; realized and unrealized gains; base and local currency performance. Costs, fees, taxes, foreign exchange, and paper versus actual profits, will all greatly impact your analysis.
Always factor in inflation rates. A 100% return may seem wonderful, but not so much if you are living in a period of hyper-inflation. See 2019 in Venezuela as a sad example of this.
And always know what return data is being presented. Massaged financial information can lead you to incorrect decisions. For example, there may be a difference between mean and median returns. There may be further variances when factoring in time weighted versus dollar weighted returns.
Portfolio Composition
A key to any analysis is an apples to apples comparison. Especially relating to portfolio risk.
And equally applicable when investing in asset subclasses as risk can vary from the overall asset class risk-return profile.
You want your benchmark to reflect the composition of your portfolio, where the benchmark is an index, peer group member or average, or target allocation.
Reflect, not necessarily exactly mirror. Unless you are investing in the index itself.
You want your portfolio to reflect the benchmark in respect of expected return and risk.
If you use a risk-free rate (i.e., Treasury bills) as a benchmark for a portfolio made up of shares in unlisted small companies, the comparison becomes irrelevant. You are trying to compare a risk-less benchmark against a high risk portfolio. Any comparative data will make no sense, other than simply knowing your performance relative to a completely safe asset.
The same holds true comparing the Dow Jones 30 to the unlisted small cap stocks. Or to Argentinian or German companies. There are different return expectations and volatility between the groups. That makes comparisons difficult.
Asset Allocation
You want your portfolio’s asset allocation to reflect your target asset allocation.
And your chosen benchmarks should also reflect your target asset allocation.
If you have a simple target asset allocation of 70% U.S. equities and 30% U.S. bonds, both your benchmark and actual portfolio should reflect this. Perhaps your selected benchmarks should be the Standard & Poor’s 500 for equities and the Barclays Capital Aggregate Bond Index for the bonds. Weighted 70% and 30% respectively.
Material Variance
A material event is one that triggers action on your part.
For example, perhaps you are considering buying a car. Color, interior design, stereo system, horse power, etc., may all play a part in your decision making. They will have a cumulative effect on your choice. But individually, the car’s color or its stereo system probably will not be a deal breaker.
Instead, a sale price, low interest financing, warranty, consumer satisfaction surveys, etc., may play more important roles in your decision. If your potential vehicle is considered a lemon, you may decide to choose a different make. Or if you can get excellent financing terms, you may be swayed in your decision. Any one factor can make or break the purchase decision.
These latter factors are material events. The key points that affect decision making.
You need to identify the make or break points in your portfolio analysis. And these points are largely driven by who you are as an investor. Your risk tolerance, investment objectives, constraints, etc. Your investor profile.
These will obviously differ from individual to individual.
For example, some risk averse investors may not be comfortable with any negative portfolio returns. Others may accept short-term or minor losses, say no more than 10% of invested capital. And others may accept losses of 25%, 50%, or more before taking remedial measures.
While you want to ensure that your portfolio does not underperform, it can be a tricky process. It is a fine line between fine tuning a portfolio and in either waiting too long to make changes or adjusting too often.
A common material review point for investments in funds is peer review. If your fund is ranked in the bottom half of its peer group over (say) 3 years, it may be worth considering a change. Either it is selecting poor investments relative to other fund companies in the same asset category. Or it is extremely costly in fees and that is dragging down results. Either way, other investment options may be preferable.
We will consider when and how to rebalance a portfolio next week.
