The Biggest Misconceptions About Portfolio Performance

15443251_sWhen I meet folks I find that many times they don’t have a financial process that would help them make logical financial decisions for their future. I find that more often than not, folks have made their financial decisions based on emotions and without knowing the relevant questions to ask in order to filter out misconceptions.
One of the biggest misconceptions I find folks have is on the actual, the real, performance of their investments. They tend to evaluate their portfolio’s performance on the 1-, 3-, 5-, and 10-year rates of return instead of analyzing the actual performance from year to year. Because markets historically go through a correction every five to six years (we are in the sixth year of a recovery), it is critical that folks analyze their portfolio’s performance during what I refer to as “the worst of times,” from 2000 to 2010. An investment’s performance during that time is a true indication of how well or how poorly an investment will perform during a market correction.
That was a discussion I had in my office last week with a very nice woman, let’s call her Barbara. Barbara is 65, retired, and has a brokerage portfolio of about a million bucks, made up of mostly mutual funds and some exchange traded funds (ETFs). She wants to begin drawing income from her investment at a rate of approximately 5 percent per year, about $50,000. Barbara told me that her broker claims her portfolio has averaged 8 percent over the past 10 years. Nevertheless, Barbara is very concerned about how a market correction will affect her portfolio and lifestyle. Barbara has reason to be concerned. Let me explain why.
Here’s what we do know: We know that Barbara’s portfolio is made up of mostly mutual funds and some ETFs. We also know that 80 percent of all mutual funds do not beat the S&P 500. Here is what we do not know: If Barbara had a million bucks in 2000, how much would she have today? It is not always what we make, I told Barbara, rather, it is what we keep.
By performing a portfolio analysis for Barbara, I found that her portfolio virtually mirrors the S&P 500 index. I explained to Barbara that 9 out of 10 brokerage portfolios I analyze fit this category. I also told Barbara that the 10-year annual rate of return for the S&P is 7.51 percent.
The uninformed investor assumes that the 10-year average rate of return reflects the true performance of their portfolio year after year. However, this number is not an accurate reflection of an investment’s actual performance.
By analyzing the performance of Barbara’s brokerage portfolio using the actual yearly rates of return, the numbers show that if in 2000 Barbara had invested $1 million in the mutual funds included in her current portfolio, Barbara’s million bucks would have shrunk to $547,000 by 2002. Her income would have shrunk from $50,000 to $27,000. In fact, she would not have made her money back until the end of 2013 and her income would only be about $42,000.
Why is this important to you, Cutter Family Finance readers? The uninformed investor does not know the questions to ask. You must ask about your portfolio’s performance beginning with the year 2000. You must quantify the actual performance of your portfolio during “the worst of times.”
You must also factor in inflation when evaluating the performance of your portfolio. President Reagan once said, “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” Assuming a 3 percent annual compounded inflation rate, the fact is that Barbara’s portfolio would have needed to grow to $1.61 million and her income would have needed to be about $81,000 just to keep up with inflation. As stated above, based on the yearly rates of return of the investments in Barbara’s portfolio, if Barbara had one million bucks invested in her current portfolio in 2000, it would have just gotten back to one million bucks this year and her income would still be lagging at $42,000, which is half of what she would need to have kept up with inflation.
This in-depth type of analysis is critical, especially in our retirement years since investment and income planning are joined at the hip. With Social Security’s Cost of Living Increases (COLI) under attack, our investments must not only keep up with inflation but beat it, and beat it consistently. Social Security COLI is hovering around 1 percent to 1.5 percent and in my opinion that is not going to change. This means that in effect, the amount of benefits you receive today are slowly being eroded due to that “mugger” inflation.
I suggested to Barbara, as I suggest to you, to pursue strategies that are hedged against inflation. Investment strategies that consistently beat inflation give you a more effective and predictable outcome so your income does not slowly erode away. If you do not take action, by the time you realize it, it may be too late.
Together Barbara and I evaluated the true performance of her investment portfolio. By doing this, Barbara was able to understand what she can reasonably anticipate when there is another market correction. She made the necessary adjustments in time to protect her retirement. Have you? Remember, it’s your money, shouldn’t you be asking the right questions? If you don’t, who will?
Be vigilant and stay alert, because you deserve more.