Start the New Year With an Investment Report Card

Published on January 1, 2011

The start of a new year is an excellent time to take stock of past accomplishments and chart a course for success in the future.  As value investors, we attempt to identify securities trading at a discount to intrinsic value that can be purchased with a substantial margin of safety.  When an investor purchases a security, by definition he or she is expecting to earn returns greater than the overall market over the anticipated holding period.  Otherwise, there is no point in going through the effort of security analysis when ultra low cost index funds are available to implement a passive strategy.

An honest assessment of investment performance is critical and every investor should compile a “report card” at least once per year.  Of course, most value investors do not turn over their entire portfolio in one year or even every five years, but tracking results annually can begin to show a pattern of success or failure over time.  How should an investor go about this process?

Obtaining Accurate Performance Metrics

It may seem obvious, but any honest assessment of performance must begin with accurate record keeping. Many investors seem to have only a vague “gut feeling” about their performance, and in many cases investors tend to make high estimates of past returns.

Fortunately many brokerages offer performance data to investors and software products like Quicken provide basic tools to measure portfolio returns.  However, many of these tools do not provide complete transparency in terms of measuring the appropriate internal rate of return for a portfolio.

For over a decade, we have found the following approach to be useful and easily implemented in Microsoft Excel:

  1. Create a listing of all open positions in the portfolio as of January 1 (or the start of the analysis period).  Any cash that is considered part of the investment program should also be included in the total portfolio value.  It is very important to avoid co-mingling cash meant for investment operations from cash used in day to day life.  The total of all positions and the investment cash equals the starting portfolio value.
  2. Create a listing of all transaction activity over the course of a year that impacts the portfolio.  Obvious examples include all purchases and sales of securities as well as dividends received and commissions paid for trades.  In addition, record any inflows of new cash into the investment account as well as any outflows of cash from the investment account.  A date should be associated with each transaction.  Also, double entry book-keeping procedures should be used.  For example, a purchase of $10,000 worth of stock would involve liquidating $10,000 of cash as well as paying a commission on the trade.
  3. Create a listing of all open positions in the portfolio as of the analysis date (usually the current date).  Include all available cash in this figure as well.  This represents the ending portfolio value.
  4. With a listing of the opening portfolio value, all transaction activity, and the closing portfolio value along with the relevant dates, Microsoft Excel’s XIRR Function can be used to arrive at the internal rate of return achieved by the overall portfolio for the measurement period.

For those who find the approach outlined above too involved, Quicken 2010’s “Investment Performance” report provides similar results although it is difficult to incorporate cash transactions based on some testing of the process.  Nevertheless, it may be good enough for some investors.

Index Benchmarks

Now that we have a figure representing portfolio performance over the past year (or any other measurement period), we must select benchmarks against which the performance may be evaluated.  Most U.S. based investors tend to use the S&P 500 index as the primary benchmark, but it is also common for fund managers to use more narrow benchmarks such as an industry specific index or a foreign index.  The idea is to select a main benchmark that an investor could realistically select as a passive alternative given the style of the active portfolio in question.

One major error that investors make repeatedly is failing to use total return figures for an index.  For example, the S&P 500 returned 12.78 percent on a price basis in 2010.  However, the total return figure was significantly higher at 15.06 percent according to the Standard & Poor’s website.  Nevertheless, the figure seen most often in newspapers seems to be the price return figure.

Since no one can directly invest in the S&P 500, costs will be incurred but many index funds have very low expense ratios, in some cases below ten basis points (0.1 percent).  Therefore, the 15.06 percent figure would have to be reduced somewhat to arrive at a passive investment benchmark.  Let’s consider this benchmark to be around 15 percent for 2010.

Other Benchmarks

While using an index benchmark such as the S&P 500 is the most common method of evaluation, there are at least two other approaches that investors can use to determine whether their security selection skills are providing value.

First, many investors have a “default” equity investment that they are particularly comfortable owning and is often either the default destination for new cash or a source of cash for other investments.  Warren Buffett has often mentioned investing in Wells Fargo as the opportunity cost that he considers when evaluating other equity investments.  Many other investors have similar views regarding Berkshire Hathaway itself.  In other words, are specific securities in the portfolio and the portfolio as a whole performing in a manner that surpasses the performance of the “default” equity investment that represents the investor’s opportunity cost?

Second, all investors should evaluate their performance against a hypothetical “do nothing” approach in which the portfolio at the start of the year remains entirely unchanged until the end of the year.  In other words, if the investor had done nothing all year, would the results have exceeded the returns actually achieved?  Obviously, a negative result in a short timeframe like one year does not necessarily imply that the portfolio changes were not warranted because it can take time for such decisions to produce positive results.  Nevertheless, it is interesting and revealing to look at this figure over a long period of time.  If an investor’s “do nothing” portfolio routinely beats the benchmark index and also beats the actual portfolio results, it likely indicates that the investor has talent for security selection but has excessive turnover in the portfolio that impedes overall progress.

Assess, Adjust, and Move Forward

While putting together an investment report card may not be the most exciting New Year’s Day task, it can be revealing and sometimes sobering.  A portfolio may beat the index benchmark but fail to achieve returns greater than the “default” equity investment or the “do nothing” portfolio.  It can be particularly jarring to find that one could have increased returns by simply leaving a portfolio alone all year.  If this happens, does it mean that it would have been smarter to leave the portfolio on auto-pilot all year and spend more time skiing or at the beach?  That is taking a leap too far since it is not possible to judge how investment decisions made in 2010 will eventually play out.

However, a candid and honest assessment of specific decisions made over the past year can be instructive.  There is no shame in selling an investment that approaches or exceeds intrinsic value even if the security advances further into a speculative valuation.  In fact, the investor must  guard against second guessing past decisions in a manner that could impede sound decision making in the future.  There is nothing like watching a sold security that advances into the speculative realm to help eat away at the value investor’s selling discipline, but resistance is important for long term results.

Disclosures:  The author owns shares of Berkshire Hathaway.

Start the New Year With an Investment Report Card