Wednesday, November 22, 2017

The Goal Oriented and the Net Worth Method of investment benchmarking


Everyday we hear about comparing your portfolio’s performance to one or more market indexes. This is a futile and unrealistic exercise.  Yes, if you have a strict Canadian stock portfolio without any cash, comparing to the TSX or the TSX60 performance may make sense.  But why do you think we build a diversified portfolio?  I see my total portfolio as all my assets. So it includes gold bullion (which I consider a form of cash); all my cash holdings which are usually concentrated in a few investment accounts (discount and full service broker accounts); Canadian and international stocks and bonds; all manner of ETFs; different forms of real estate; my career ; art and other thingies.  You know, most personal finance software is incapable of calculating the returns on a ‘portfolio’ such as this; so even if it was realistic to compare it with, say the S&P500 returns it wouldn’t be able to.

There are two meaningful ways to estimate how your ‘portfolio of everything’ (i.e. Net Worth) is doing.  One is, what I call the Net Worth Method and the second is the Goal Oriented Method and they are somewhat related.

The Goal Oriented Method:

As discussed on this blog many times, every investment journey starts with a vision – as it is sometimes referred to by REIN members: Your Belize.  You set up a vision of your life; for example: at age 40 I want to live in a villa on Belize and never ever work again. I will catch fish on the beach and die of skin cancer because I will be sitting all day in the full sun while drinking tequila.  😊  Or it could be:  at age 39 and half, I will have my house paid off and 1 million in the bank.  I won’t be any longer dependent on a wage-earning job and tell my boss that he can take a hike (if he/she doesn’t behave).

At the end of every year you ask yourself:  Did I get closer to my goal?    If so, am I going to reach my goal still in 10 years or will it be only 8 years or even faster?  That is really all that counts. You may realize that you can also ask in a more abstract way:  How many years will it take before I reach my Net Worth goal.  This is probably most practical because what you dream of as a 25-year-old is probably quite a different life than when you’re 50. So, I like the Net Worth goal.  By Fifty, I want to have all the money I need to do the projects and things I consider doing worthwhile in life.  Maybe that would constitute a paid off dream home of $1 million and another $ 2 million in a diversified stock and bond portfolio and or in a business I started and own.  Add it up and your Net Worth goal is $3 million

That brings us to the second ‘benchmark’ method: The Net Worth Method:

So now you ask your self every year:  over the past 3 or the past 5 years, by how much did my net worth increase?  You can even express that in numbers.  I like to do this over a 3 or a 5-year period because shorter may be too volatile a performance that is really not representative of your long term performance. It is the latter that counts. Example: What is you net worth now?  Say $1,000,000 and it was $750,000 three years ago.  So you gained $250,000 over three years or a return of 250000/750000 =  33.3% or close to a 10% compound return rate. If you want to go even fancier, guestimate how long it would take you at 10% growth to reach your net worth goal of $3,000,000.  You own a million now and using the rule of 72 you now can estimate that at a 10% annual return you double your net worth in 72/10= approx. 7years. Thus, in seven years you own $2,000,000 and in 14 years you own $4,000,000.  Done! You will reach your goal somewhere within 7 to 10 years. Now you know how you are doing and whether you are on the right track.  It doesn’t have to be more complex like that.

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