Thursday, June 4, 2015

How do you know whether your investments are performing OK?

This is a perpetual question amongst investors; doesn’t matter whether you’re novice or highly experienced.  That is because your expectations are often shaped by the ‘benchmark’ but these benchmarks continuously change.   Some say you should compare yourself with a stock market benchmark. Which stock market? Canada’s, Europe’s?  What about exchange currencies.  Yeah Europe is up big time in Russian Rubbles but its performance is mediocre if not outright atrocious when measured in US dollars.  In an earlier post we discussed that you have to diversify not only amongst countries but also amongst asset classes.  But when you compare the total portfolio’s return it hardly ever measures up to say the S&P500 index.  The previous post explains why.  So even if you knew what country’s stock market to use as a benchmark, your overall portfolio performance is going likely to be less.

Most of us calculate our returns on a pre-tax basis.  Comparing your after-tax returns to the S&P would be preposterous.  Comparing your TSFA returns against S&P500 returns is a lot more realistic (since you don't pay taxes on your returns) but only if you investing mainly in U.S. stocks.  What about investing, as most Canadians do, overweight in the Canadian stocks?  If you invest solely in Canadian Banks you may have outperformed the TSX300 benchmark but you likely underperformed the S&P500!   So are you doing good or bad?
Many corporations evaluate investments risked or unrisked based on the time value of money (Net Present Value or money discounted at a rate that is supposed to represent the cost of money over time). Problem is, that for years if not decades, the discount rate typically is 10% regardless whether inflation is zero, negative or plus 10%. So what is good performance? 

When everything is said and done, investing should be measured in terms of purchasing power.  Over the long term, we want to live of our investments forever; even better hopefully we have a portfolio that keeps on increasing in purchasing power over time. Problem is that over the last 40 or so years, inflation averaged 4% per year; yet for individual years it fluctuated wildly. In the early 1980s, inflation was as high as 12% and today we’re afraid of deflation.  So yes, on average inflation may have hovered around 4% but I am sure that during the 1982-2000 bull market returns of 6 to 8% were not considered decent performance.  So let’s assume that on average the stock market returned inflation plus 6% (as estimated by Jeremy Siegel), then in the early 1980s returns should have been as high as 12% inflation plus 6% real return totaling 18% and in today’s zero inflation world satisfactory stock market returns should have been zero plus 6 percent, i.e. around 6%.  And. don't forget, the stock market is typically the highest returning asset class.
In today’s stock market averaging 6% per year feels slow and frustrating, but it is nearly all ‘real return’ (adjusted for zero% inflation).  But you still have to pay taxes – often nearly 50% of your profits. This would destroy your investment returns. If you truly want to grow your net worth in purchasing power, you will have to pay as little investment fees and taxes as possible.  Reducing your investment fees is simple: buy and hold. If you don’t sell you don’t pay capital gains taxes -  your investments will grow much faster when you only buy and never sell. Better yet, sell your losers and hold-on to your winners, preferably hold on to your winners forever.  If you sell your losers you create tax credits which you can use to reduce your taxes on the profits made by selling winners. 
For example, your portfolio has owned shares in Brookfield (Symbol: BAM) for many years. Today your stock portfolio holds more than 10% BAM stock – rules of diversification state that you should hold no less than 20 different public companies or a maximum of 5% per investment in your stock portfolio.  You can use tax credits earned from the sale of losing stocks (triggered e.g. by a stop-loss price 25% below the purchase price) to offset taxes on the profits from your portfolio rebalancing sale of Brookfield shares. Other ways to protect yourself from the tax man is investing using my favorite TSFA account and second to that the old stoogie of an RRSP account.
Always use your dividend, rental income and interest income to create cash hoards for new investments or increase the size of existing holdings keeping the rules of diversification in mind (max 5% of your stock portfolio). Sometimes your cash hoard gets augmented by the sale of losing stock holdings or sales stemming from rebalancing your portfolio. And of course, you can increase your cash hoard by adding the savings from your salary or self-employment income. Don’t fear market volatility (which is easier said than done).  Use downturns as opportunities to buy shares and other investments at the right price – at a discount of intrinsic value.
In conclusion: If you are making a return between 5 and 6% per annum in today’s markets you are doing good. Above 6% and you’re doing great. Below 4% per annum returns should alert you to look for ways to improve. Most likely, you have too much cash and too many ‘low risk – low return’ assets or you’re trading too much triggering taxes and transaction fees.