While it might not seem like it, understanding and contextualizing investment performance can be surprisingly difficult. In this episode, we share our framework for doing just that. We explain what makes up investment performance, how to have proper context around investing, the different ways to calculate investment returns, how to understand whether your investment return is “good” or “bad,” and how to tie it all together to the big picture and what matters for your situation.
Outline of this episode
- What makes up investment performance? [1:11]
- Having proper content around your investments [5:02]
- Calculating your investment return [8:32]
- The only benchmark you should compare to [12:39]
- The return needed to meet your goals [14:12]
- The recap [16:51]
Understanding your performance in the proper context
The first step to viewing your investments is to understand your unique goals and time horizons for what you are saving and investing towards. That provides the "why" behind the mix of investments you have. From there, it's helpful to understand what makes up your investment return, which is referred to as your total return, and is a combination of both interest and dividends from your investments along with the appreciation or depreciation and the price of your investments. Add those two together and that's your total return.
The next step is to have the proper context for looking at your investment performance, which starts by ensuring you're comparing apples to apples. In order to have the proper context, you need to understand the time horizon you're looking at. Is it a one-day performance, a three-month performance, or 20+ years' worth of performance? You also want to look at the different types of investments. Comparing stocks versus stocks and bonds versus bonds, because that allows you to drill deeper into why you are doing better or worse than other investments.
Determining if you are having good or bad performance
When looking at your investment performance, there are two main ways to determine your investment performance. Time-weighted investment return, which is simply the return of your investments over a period of time, and internal rate of return, which takes into account the cash inflows and outflows of your investments. Over shorter periods of time, there may be a larger delta between the two reporting performances based on whether you had lucky or unlucky timing when you invested money. Over time, these two performance calculations tend to converge.
After you have an understanding of what your unique return was, or is, make sure you're looking at the right benchmark. In our opinion, the right benchmark is the return that's required to meet your goals. That allows you to determine if you are doing good or bad, at least over the near term, but the focus should always be on the longer term.
Investment performance is always relative and it's unique to each person as to whether it's good or not good enough.
The bottom line
The last point is the importance of the bottom line return after taxes and inflation are factored in and what that means for your unique situation. It's not to beat an arbitrary benchmark or compare yourself to your neighbor or colleague.
Looking at this return highlights the importance of investing in order to keep up with the rising cost of living while ideally growing at several percentage points above that, which ultimately allows you to grow your wealth in real terms and eventually live off of your savings and investments to fund your retirement lifestyle over a 30+ year time horizon. This also helps you to realize if you need (or have the luxury of not needing) a higher return in order to meet your goals.
Resources & People Mentioned
- Download our guide: The Toolkit for Optimizing Your Finances as an Employed Physician
- Download our guide: The Financial Checkup