This is one of those boring articles about investing that is actually very important. To liven things up, J.D. has illustrated this article with photos of one of his cats.
It's quiz time, folks. See if you can answer any or all of the following questions:
- Do you know what your entire portfolio earned over the past year?
- What's your best-performing investment? Your worst?
- If you invest in mutual funds, do you know how many of your funds are beating their benchmarks?
- Would you have been better off investing in a collection of index funds?
Did you have answers to all those questions? If you did, how confident are you that your responses are accurate?
My experience talking to friends, family, and, yes, even Motley Fool colleagues is that most investors have only a vague idea of how their portfolios have performed. I've found confirmation in a survey of German investors conducted by professors Markus Glaser and Martin Weber, who also were able to analyze the investors' online brokerage accounts. They found that the returns were an average of 11.5 percentage points worse than the investors had thought; only 5% of survey respondents reported negative returns, but in reality 25% had losing portfolios.
Ignorance is NOT bliss
If your definition of “get rich slowly” includes putting at least some of your savings somewhere besides the bank, then chances are you spend time and money trying to identify better-than-average investments. You might do a lot of research in an attempt to pick outstanding stocks. Maybe you scrutinize data to identify exceptional mutual funds. Perhaps you regularly adjust your asset allocation to maximize returns. Or maybe some of your money is managed by an investment advisor. But unless you keep tabs on your returns and compare them to the proper benchmarks, you won't know whether any of these efforts are paying off — or whether you'd have tens of thousands more dollars if you'd only done something else.
No, you shouldn't look at your investments each and every day — that way lies madness — but once a year, you do need to evaluate the returns of your investments and the skills of the people who are picking them, be they mutual fund managers, financial advisors, or that good-looking investor in the mirror.
Convinced? Great. As with most worthwhile pursuits, though, the process isn't a simple one. You really have two questions to answer:
- Do you have the best individual investments? Is your international stock fund the right one for you? Has the stock you purchased two years ago lived up to your expectations?
- Do you have the right mix of investments? How has your stew of cash, bonds, and stocks fared over the past few years? Are you — or your advisor — making overall asset allocation decisions that compare favorably to what others are doing?
The first place to look for answers is your account statements, especially since you'll begin receiving year-end statements soon. Those will display your returns, which is a start. But determining whether those returns are good, relative to similar investments and what you could have earned elsewhere, will require another step.
A quick and easy way to evaluate a single investment more fully is to enter its ticker on Morningstar.com and click on “Performance” in the gray area under the investment name and ticker. You'll find year-by-year and annualized longer-term return information, as well as comparisons to similar investments.
Here's what to look for, depending on the type of investment:
Morningstar provides total return numbers (which includes changes in the stock price as well as dividends) and compares them to the returns of the company's overall industry. It also compares the stock's performance to the S&P 500, which is not the appropriate benchmark in most cases, since it's an index of mostly large U.S. stocks. Rather, small-cap stocks should be compared to a small-cap index, emerging-market stocks to an emerging-markets index, and so on. You can find a clue to the stock's appropriate benchmark on its main “Quote” page on Morningstar by clicking on “Company Profile.”
Once you have a handle on the kind of stock you own, you'll need to compare its performance to a similar index or index fund over a period that approximates your holding period. It may not be meaningful if a few of your stocks are underperforming their indexes; if your investment thesis remains solid, they may just be even better bargains now than when you bought them. However, if over a three- to five-year period your similar stocks, as a group, are underperforming a relevant index fund, then it might be time to re-evaluate your stock-picking process (and prowess).
Besides providing total return information, Morningstar ranks the performance of a mutual fund compared with other funds with similar investment objectives. Look in the “% Rank in Category” row on the “Performance” page, and choose a time frame that is long enough to be meaningful — at least five years, preferably 10. The lower the number, the better. For example, you'll find a 6 in the “5-Year” column for the Dodge & Cox International Fund (DODFX), which means its performance ranks among the top 6% of funds that invest in large-cap value international stocks.
Over the long term, approximately two-thirds of actively-managed funds underperform their indexes. If your actively-managed fund doesn't score a 33 or higher in the “% Rank” row over a five-year period, and especially over a 10-year period, it's among that less-than-illustrious group, which means it's time to reconsider the fund.
If you're holding a fund outside your tax-advantaged retirement accounts (like a Roth IRA or a 401(k)), the next step is to compare the fund's after-tax returns to other funds in its category. To do this, enter the fund's ticker on Morningstar.com, then click on “Tax” in the gray area under the fund's name and ticker. There, you'll see how much of the fund's return was handed over to Uncle Sam, assuming the highest individual tax bracket of 35%. The average equity mutual fund has a “tax-cost ratio” between 1 and 1.2, which means an investor in that average fund loses 1.0% to 1.2% of return to taxes every year.
Given that the large majority of investors are not in the top tax bracket, the amount lost to taxes is not quite so bad for most people. But it's still something to monitor for the funds you hold outside IRAs and 401(k)s — especially if the fund is barely beating a comparable index fund, since index funds' tax-cost ratios tend to be just one-fourth to one-half those of similarly invested actively managed funds.
Exchange-Traded Funds (ETFs)
In the 1990s and early 2000s, an ETF was just an index fund that traded like a stock. Not anymore. Now, many ETFs are investment strategies disguised as index funds. There are a ton of them, and not all of them perform the same. For example, there are 11 U.S. small-cap blend ETFs (“blend” indicates that the fund is not strongly value- or growth-oriented), according to Morningstar's ETF Performance tool. Their annualized returns over the past three years range from -0.5% a year to 11.8% a year. Obviously, you want to make sure your ETFs are among the better performers.
Given their reputation for tax efficiency, ETFs are often purchased outside of tax-advantaged retirement accounts. But their tax efficiency varies, so if you hold ETFs outside an IRA or 401(k), make sure you're keeping as large a percentage of your returns as possible by checking your funds' tax-cost ratio on the Morningstar “Tax” page.
Tasting the Whole Enchilada
Evaluating an entire portfolio is trickier, since investors tend to have accounts scattered about — perhaps a 401(k) here and an IRA over there — and choosing the right benchmark isn't always clear. If all your investments are with one firm, then you should have a good idea of how your overall portfolio has performed. Otherwise, you need to use financial tools such as Quicken, Wikinvest, or online portfolio trackers at Morningstar.com, Yahoo Finance, or Google Finance. However, this is crucial: Make sure you're measuring of the performance of your investments, and not counting cash contributions to your account as investment growth (as the Beardstown Ladies did in the 1990s).
Once you know how well your investment performed as a group, what do you compare it to? My suggestion is a similarly allocated target retirement mutual fund from fund company Vanguard. These mutual funds provide instant asset allocation — a prudent mix of cash, bonds, and stocks (both U.S. and international) based on a general retirement date. As that date approaches, the allocation becomes gradually more conservative — which is what most investors should do. Since the fund is from Vanguard, the money is invested in a collection of low-cost index funds. If your investments, as a group, are losing to a target retirement account, it might be time to invest in one instead.
Is anyone still reading?
If you're still with me, I commend you. This is pretty boring, technical stuff. But it's crucial. Too many investors spend their lives choosing below-average investments, often paying financial advisors and mutual fund managers for below-average returns. The result: These investors reach their sixties with tens of thousands of dollars — maybe hundreds of thousands of dollars — less than what they could have had. Don't be another financial-services sucker. Keep your advisor, fund manager, and/or yourself accountable.