Measuring Portfolio Performance

It sounds like a simple topic - measuring portfolio performance - so why do so few investors, both amateur and professional, do it so poorly?

The answer should be simple: The way to measure portfolio performance is annual compounding rate of return.

So, how (and why) does it get complicated?

Firstly, many investors are not proud of their performance, and will therefore try and mask their poor performance.  This comes in many forms:

• Reporting only the highlights:  "Fund manager of 2010".
• Reporting over a shorter time-frame than the fund has existed: "20% last year"
• Reporting cumulative results rather than annual results: "80% over last 10 years"
• Erroneously averaging yearly results.  Eg, +20 and -20 does not average 0.
• Reporting "relative" performance, rather than actual: "Outperformed market (-15%) by 3%"
• Reporting without consideration to inflation.

And that's just off the top of my head.  Next time a fund management company tries to sell you their services - see which one (or more) they use.

Another way that it get's complicated is dealing with injections and withdrawals of funds from the portfolio over time.  Consider the case where you make an initial bank deposit of $100,000 and then monthly contributions of $1,000 over three years.  If, at the end of the 3 years, you have $150,000 in the bank account, what was it's performance (assuming interest calculated daily, paid monthly, and did not change)?

This should be simple to do.  If you actualy opened this account, you would already know the performance, because it would be the same number as the interest rate of the account.  However, back calculating this off the end figures to determine the annual compounding rate of return is not so simple.

The best way that I can think to do it, is to put the entire scenario, that is, initial capital outlay, deposits and withdrawals over time, including dividends, into a spreadsheet.  Then, try a series of possible performance answers (eg, 5.9, 6.0, 6.1, 6.2) and, for each, forward calculate the final position.  The final position that is closest to your current position will then give you your fund performance.

As an amateur investor, there is a final trap to be aware of - the secret funds delusion.   Were all of your "deposits" really new funds?  Or, were the funds available the whole time, and you only recently transferred them from your 0% interest everyday account into your investment account.  Sorry, this doesn't count.  You need to ensure that you include "all investment funds" to determine you "overall investing performance".  If you are silly enough to leave $100,000 in a 0% account - this counts as bad performance!

So, how's your investing performance?  Do you know the number?