This question actually came in just before I wrote about using Morningstar to track your investments against an appropriate benchmark, but it is certainly worth answering for the benefit of others as well. Understanding what you should be comparing your investments to will give you a clear picture of how well you’re doing, and whether or not you need to make changes.
Don’t Listen to Friends or Co-workers
This is a big mistake. How many times have you been having lunch in the break room when another co-worker begins bragging about their investment performance? They might be spouting off 20% returns, and you begin thinking to yourself about whether or not you’re experiencing the same kind of performance. Entertain them by listening to their story, but don’t rush back to your computer and pull up your 401k statement to see if you’re earning 20% as well.
The problem is that everyone has different levels of risk tolerance and investment objectives. Just because your brother is invested in some micro-cap China fund and doubling his money doesn’t mean it is something you should be invested in. There will always be people making more than you, and there will always be people making less than you. The key is determining whether or not your specific investments are doing what they are supposed to.
Use Benchmarks to Measure Your Success
The only way you can accurately determine how well your portfolio is performing is to compare it to a similar benchmark. If you saw a return of 40% last year, you probably think that is fantastic, right? Well, what if the benchmark for a similar portfolio returned 60% over the same period? Now your investments don’t look so hot as you’ve left a lot of money on the table.
I’m not going to go over the process of finding a benchmark step-by-step, since you can read that in the article I wrote about using Morningstar, but the basic premise is that you need to first understand how your portfolio is constructed. Is it heavy on domestic large-cap? Does you have a sizable bond position? Are you focused on international companies? If you don’t know what your investments are made of, you’ll never be able to accurately compare it to the right benchmark.
Check Regularly, but Not Too Often
You certainly want to keep tabs on your performance, but don’t fall into the habit of checking too often. The markets are volatile, and over the course of a few weeks or months, you can see some variation between your holdings and benchmarks. That’s fine in the short-term, but you will want to monitor your performance about once, maybe twice a year.
If you do notice that your small-cap growth portfolio is lagging a small-cap growth benchmark by more than a few percentage points, you may want to examine your holdings and find out why. The same goes if you find your holdings significantly outperform the benchmark. In many cases, it is simply due to style drift. This is when the managers begin to go astray from the fund objectives. It might be a growth fund, but they could be investing in more value stocks in an effort to improve performance. This can ultimately throw you off your target asset allocation.
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About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.