Evaluating Performance

1. Introduction

Choosing investments is just the beginning of your work as an investor. As time

goes by, you’ll need to monitor the performance of these investments to see how
they are working together in your portfolio to help you progress toward your
goals. Generally speaking, progress means that your portfolio value is steadily
increasing, even though one or more of your investments may have lost value.

On the other hand, if your investments are not showing any gains or your
account value is slipping, you’ll have to determine why and decide on your next
move.

To assess how well your investments are doing, you’ll need to consider several
different ways of measuring performance. The measures you choose will depend
on the exact information you’re looking for and the types of investments you own.

For example, if you have a stock that you hope to sell in the short term at a profit,
you may be most interested in whether its market price is going up, has started to
slide or seems to have reached a plateau. On the other hand, if you’re a buy-
and-hold investor more concerned about the stock’s value 15 or 20 years in the
future, you’re likely to be more interested in whether it has a historical pattern of
earnings growth and seems to be well positioned for future expansion.

In contrast, if you’re a conservative investor or you’re approaching retirement,

you may be primarily interested in the income your investments provide. You may
want to examine the interest rate your bonds and certificates of deposit are
paying in relation to current market rates and evaluate the yield from stock and
mutual funds you bought for the income they provide.

In measuring investment performance, you want to avoid comparing apples to

oranges. Finding and applying the right evaluation standards for your
investments is important. If you don’t, you might end up drawing the wrong
conclusions. For example, there’s little reason to compare yield from a growth
mutual fund with yield from a Treasury bond, since they don’t fulfill the same role
in your portfolio. Instead, you want to measure performance for a growth fund by
the standards of other growth investments, such as a growth mutual fund index
or an appropriate market index.

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2. Yield

Yield is one type of fairly straightforward income-based performance measure. It

is typically expressed as a percentage, and is a measure of the income an
investment pays during a specific period, typically a year, divided by the
investment’s price. All bonds have yields, as do dividend-paying stocks, most
mutual funds and bank accounts including certificates of deposit (CDs).

Yields on Bonds

When you buy a bond at issue, its yield is the same as its interest rate or coupon
rate. The rate is figured by dividing the yearly interest payments by the par value,
usually $1,000. So if you’re collecting $50 in interest on a $1,000 bond, the yield
is 5 percent.

However, bonds you buy after issue in the secondary market have a yield that
may be different from the stated coupon rate because the price you pay is
different from the par value. Bond yields go up and down depending on the credit
rating of the issuer, the interest rate environment and general market demand for
bonds. The yield for a bond based on its price in the secondary market is known
as the bond’s current yield.

For instance, a bond with a par value of $1,000 with a 6 percent coupon rate
might be sold in the market at a current yield of 5 percent. The bond itself keeps
paying 6 percent of $1,000 every year, or $60. But because interest rates have
fallen to 5 percent and newly issued bonds pay a lower coupon rate, a bond
paying 6 percent is more attractive to investors. If you want to buy that bond, you
will likely pay a premium—say, $1,200 instead of $1,000. If you divide the fixed
annual income ($60) by the new market price ($1,200), you get the current yield
(5 percent).

If you intend to hold a fixed-rate bond to maturity, the bond’s coupon yield might
be the only thing that matters to you since the coupon yield doesn’t change after
issue. However, current yield can matter a great deal if you’re considering selling
a bond before its maturity date. That’s because bond yields go down when bond
prices go up. As a result, you can often sell a bond you bought at the time of
issue for a profit when the current yield is lower than the coupon rate because at
that point the market price is higher than the price you paid.

Current yield might matter to you as well if the yield you’re getting on older bonds
is lower than the current yields of more recently issued bonds. In that case, you

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might consider selling your bonds even at a loss if you’d like to reinvest to get
higher yields while they’re available.

There are also two more complex and complete measures of bond yield that take
other factors into account: Yield-to-maturity (YTM) and yield-to-first call.

Yield-to-maturity is the overall interest rate earned by an investor who buys a

bond at the market price and holds it until maturity. Mathematically, it is the
discount rate at which the sum of all future cash flows (from coupons and
principal repayment) equals the price of the bond. YTM is often quoted in terms
of an annual rate and may differ from the bond’s coupon rate. It assumes that
coupon and principal payments are made on time. It does not require dividends
to be reinvested. Further, it does not consider taxes paid by the investor or
brokerage costs associated with the purchase. There are a number of online
calculators that you can use to help figure YTM on a particular bond, and your
broker or other investment professional can provide YTM figures as well—along
with a fuller explanation of how to use the information.

Similarly yield-to-first-call helps you evaluate the yield a callable bond would
actually provide if the bond issuer chose to call, or redeem, the bond on the first
date that was possible. (When a bond is callable, the issuer has the right to repay
the principal and stop interest payments on dates that are set at the time of
issue.) If a bond paying higher than current rates is called—as is often the case
—you not only lose that source of income but must often reinvest at a lower yield.
So the yield-to-first-call can be a useful tool as you compare bonds you are
considering. For example, you might prefer a bond whose initial call date is
further in the future or one without a call provision.

Yields on Other Investments

If your assets are in conventional certificates of deposit (CDs), figuring your yield
is easy. Your bank or other financial services firm will provide not only the interest
rate the CD pays, but its annual percentage yield (APY). In most cases, that rate
remains fixed for the CD’s term.

For a stock, yield is calculated by dividing the year’s dividend by the stock’s
market price. You can find that information online, in the financial pages of your
newspaper and in your brokerage statement. Of course, if a stock doesn’t pay a
dividend, it has no yield. But if part of your reason for investing is to achieve a
combination of growth and income, you may have deliberately chosen stocks that
provided a yield at least as good as the market average.

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However, if you’re buying a stock for its dividend yield, one thing to be aware of is
the percentage of earnings that the issuing company is paying to its
shareholders. Sometimes stocks with the highest yield have been issued by
companies that may be trying to keep up a good face despite financial setbacks.
Sooner or later, however, if a company doesn’t rebound, it may have to cut the
dividend, reducing the yield. The share price may suffer as well. Also remember
that dividends paid out by the company are funds that the company is not using
to reinvest in its businesses.

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3. Return

Your investment return is all of the money you make or lose on an investment. To
find total return, generally considered the most accurate measure of return, you
add the change in value—up or down—from the time you purchased the
investment to all of the income you collected from that investment in interest or
dividends. To find percent return, you divide the change in value plus income by
the amount you invested.

Here’s the formula for that calculation:

(Change in value + Income) ÷ Investment amount = Percent return

For example, suppose you invested $2,000 to buy 100 shares of a stock at $20 a
share. While you own it, the price increases to $25 a share and the company
pays a total of $120 in dividends. To find your total return, you’d add the $500
increase in value to the $120 in dividends and to find percent return you divide by
$2,000, for a result of 31 percent.

That number by itself doesn’t give you the whole picture, though. Since you hold
investments for different periods of time, the better way to compare their
performance is by looking at their annualized percent return. For example, you
had a $620 total return on a $2,000 investment over three years. So, your total
return is 31 percent. Your annualized return is 9.42 percent. This is
derived by: (1+.31)(1/3) - 1 = 9.42%.1

If the price of the stock drops during the period you own it, and you have a loss
instead of a profit, you do the calculation the same way but your return may be
negative if income from the investment hasn’t offset the loss in value.

Remember that you don’t have to sell the investment to calculate your return. In
fact, figuring return may be one of the factors in deciding whether to keep a stock
in your portfolio or trade it in for one that seems likely to provide a stronger
performance.

1
The standard formula for computing annualized return is AR=(1+return) 1/years- 1

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In the case of bonds, if you’re planning to hold a bond until maturity you can
calculate your total return by adding the bond income you’ll receive during the
term to the principal that will be paid back at maturity. If you sell the bond before
maturity, in figuring your return you’ll need to take into account the interest you’ve
been paid plus the amount you receive from the sale of the bond, as well as the
price you paid to purchase it.

There are several things to keep in mind when you evaluate return, however:

1. To be sure your calculation is accurate, it’s important to include the

transaction fees you pay when you buy your investments. If you’re
calculating return on actual gains or losses after selling the investment,
you should also subtract the fees you paid when you sold.

2. If you reinvest your earnings to buy additional shares, as is often the case
with a mutual fund and is always the case with a stock dividend
reinvestment plan, calculating total return is more complicated. That’s one
reason to use the total return figures that mutual fund companies provide
for each of their funds over various time periods, even if the calculation is
not exactly the same result you’d find if you did the math yourself.

One reason it might differ is that the fund calculates total return on an
annual basis. If you made a major purchase in May, just before a major
market decline, or sold just before a market rally, your result for the year
might be less than the fund’s annual total return.

3. It’s also important to consider after-tax returns in measuring performance.

For example, interest income from some federal or municipal bonds may
be tax-exempt. In this case, you might earn a lower rate of interest but
your return could actually be greater than the return on taxable bonds
paying a higher interest rate.

After-tax returns are especially important in your taxable accounts, since

every year the amount you can reinvest is reduced by the taxes you pay,
and the effect of smaller reinvestment amounts increases with time—a
kind of compounding, but in reverse. This phenomenon is sometimes
described as opportunity cost. That’s one reason you may want to
emphasize investments that don’t pay much current income in your
taxable accounts. In tax-deferred accounts, taxes are less of an issue
since no tax is due when the earnings are added to your account, though
you will owe tax when you withdraw.

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 4. With investments you hold for a long time, inflation may also play a big
role in calculating your return. Inflation means your money loses value
over time. It’s the reason that a dollar in 1950 could buy a lot more than a
dollar in 2013. The calculation of return that includes inflation is called real
return. You’ll also see inflation-adjusted dollars called real dollars. To
approximate your real return, you subtract the rate of inflation from your
percentage return. In a year in which your investments returned 8 percent
but inflation sent prices rising 3 percent, your real return would be only
about 5 percent.

As you gain experience as an investor, you can learn a lot by comparing your
returns over several years to see when different investments had strong returns
and when the returns were weaker. Among other things, year-by-year returns can
help you see how your various investments behaved in different market
environments. This can also be a factor in what you decide to do next.

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4. Capital Gains and Losses

Investments are also known as capital assets. If you make money by selling one
of your capital assets for a higher price than you paid to buy it, you have a capital
gain. In contrast, if you lose money on the sale, you have a capital loss. Capital
gains and losses may be a major factor in your portfolio performance, especially
if you are an active investor who buys and sells frequently.

In general, capital gains are taxable, unless you sell the assets in a tax-free or
tax-deferred account. But the rate at which the tax is calculated depends on how
long you hold the asset before selling it.

Profits you make by selling an asset you’ve held for over a year are considered
long-term capital gains and are generally taxed at a lower rate than your ordinary
income. However, short-term gains from selling assets you’ve held for less than a
year don’t enjoy this special tax treatment, so they’re taxed at the same rate as
your ordinary income. That’s one reason you may want to postpone taking gains,
when possible, until they qualify as long-term gains.

With some investments, such as stocks you own outright, you can determine
when to buy and sell. You will owe taxes only on any capital gains you actually
realize—meaning in those instances where you’ve sold the investment for a
profit. And even then you may be able to offset these gains if you sold other
investments at a loss.

Mutual funds are different from stocks and bonds when it comes to capital gains.
As with a stock or a bond, you will have to pay either short- or long-term capital
gains taxes if you sell your shares in the fund for a profit. But even if you hold
your shares and do not sell, you will also have to pay your share of taxes each
year on the fund’s overall capital gains. Each time the managers of a mutual fund
sell securities within the fund, there’s the potential for a taxable capital gain (or
loss). If the fund has gains that cannot be offset by losses, then the fund must, by
law, distribute those gains to its shareholders.

If a fund has a lot of taxable short-term gains, your return is reduced, which is
something to keep in mind in evaluating investment performance. You can look at
a mutual fund’s turnover ratio, which you can find in a mutual fund’s prospectus,
to give you an idea of whether the fund might generate a lot of short-term gains.
The turnover ratio tells you the percentage of a mutual fund’s portfolio that is
replaced through sales and purchases during a given time period—usually a
year.

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Exchange-traded funds (ETFs) can be a bit more complicated when it comes to
capital gains. As with any investment, you will have to pay either short- or long-
term capital gains taxes if you sell your shares for a profit. The actual rate you
will pay, however, depends on the ETF’s structure and the type of assets it holds.
While most ETFs are structured as investment companies, some may be
structured as trusts or limited partnerships. In addition, ETFs can hold a variety of
assets—equity, bonds, or commodities, among others— that may trigger different
capital gains tax rates. In some cases, the ETF’s own capital gains may cause
you to owe taxes even if you have not sold your shares. For these reasons, it is
very important that you understand how any ETF is structured and what asset
category it holds before you invest.

Unrealized gains and losses—sometimes called paper gains and losses—are the
result of changes in the market price of your investments while you hold them but
before you sell them. Suppose, for example, the price of a stock you hold in your
portfolio increases. If you don’t sell the stock at the new higher price, your profit
is unrealized because if the price falls later, the gain is lost. Only when you sell
the investment is the gain realized—in other words, it becomes actual profit.

This is not to say that unrealized gains and losses are unimportant. On the
contrary, unrealized gains and losses determine the overall value of your portfolio
and are a large part of what you assess in measuring performance, along with
any income generated by your investments. In fact, many discussions of
performance in the financial press, especially regarding stocks, focus entirely on
these price changes over time.

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5. Tracking Performance

One of the most important things you can do when tracking your investments is
to have realistic expectations and to compare performance against an
appropriate measure. A percentage return that could be considered weak in one
market or economic environment might be considered strong in another. There’s
no single, unchanging standard—for instance, that all stocks should return a
specific percentage each year. Instead, performance standards are moving
targets—and historical returns are typically averages. That’s why it’s important to
judge an investment in the context of your portfolio strategy as well as against an
appropriate standard or benchmark.

Using benchmarks

Generally, when people refer to the stock market’s performance, they’re actually
referring to the performance of an index or average that tracks representative
stocks or bonds. The index serves as an indicator of the overall direction of the
market as a whole, or of particular market segments. Investors use these indexes
and averages as benchmarks, to see how particular investments or combinations
of investments measure up.

For example, when a mutual fund manager says the fund’s objective is to “beat
the market,” it generally means the manager attempts to assemble a portfolio
that has a stronger return than a particular benchmark. In contrast, the objective
of index mutual funds is to replicate the performance of the market they track and
the fund managers typically structure their portfolios by purchasing all of or a
sample of the investments that make up their chosen benchmark.

Though the terms “index” and “average” are sometimes used interchangeably,
they’re actually quite different because of the way they’re calculated. Averages
add up all the prices of the investments included in their roster and divide by the
number of investments. Indexes, on the other hand, set a base starting value for
their holdings at some point and then calculate percentage changes from that
base. The best-known market measurement, the Dow Jones Industrial Average,
is called an average but it’s actually calculated using a blend of the two
approaches.

Some of the more frequently cited indexes and averages are these:

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  Dow Jones Industrial Average. The most widely cited measure of
the market, the DJIA tracks the performance of 30 stocks of large,
well-known companies.
 S&P 500 Index. Standard and Poor’s index tracks 500 stocks of
large U.S. companies and is the basis for several index mutual
funds and exchange-traded funds.
 Russell 2000. This index tracks 2,000 small-company stocks and
serves as the benchmark for that component of the overall market.
 Dow Jones Wilshire 5000. Tracking over 5,000 stocks, the
Wilshire covers all the companies listed on the major stock
markets, including companies of all sizes across all industries.
 Lipper Fund Indexes. Lipper calculates several indexes tracking
different categories of mutual funds, such as Growth, Core or Value
funds.
 Barclays Capital Aggregate Bond Index. This is a composite
index that combines several bond indexes to give a picture of the
entire bond market.

When choosing a benchmark, it’s important to know what you’re comparing your
investment against and what the comparison means. For example, when you
compare a stock’s performance to the performance of the S&P 500, you’re
comparing it to U.S. large-company stocks. When you compare it to the Russell
2000, you’re comparing it to small-company stocks. When you compare it to the
Dow Jones Wilshire 5000, you’re viewing it against the field of all listed U.S.
stocks.

Which benchmark should you use? In general, if you want to know how an
investment is performing you look at the benchmark that tracks investments that
are most like it.

For example, it makes sense to compare the performance of a large-company

stock or large-company mutual fund to large-company stock indexes, and small-
company stocks or funds to small-company stock indexes. If you’re concerned
with how your stock is faring against others in its industry, you compare it against
an industry benchmark. Comparing an investment to a vastly different benchmark
may give you some information. For example, you may discover that your small-
company stock fund isn’t performing as well as the total stock market.

But that information might be of limited use, especially if small-company stock

funds are an important part of your portfolio mix that you have included because
they perform differently from the total stock market, and so you could reduce the

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risk of your portfolio. Instead, if you compare your small-cap stock fund against a
small-cap index, and your fund is actively managed, you’ll get a sense of whether
your fund manager is performing well after the fees the fund is charging, or if you
might be better off investing in a passively managed small-cap index fund.

There are, however, valid reasons for making cross-category comparisons when
evaluating the performance of your entire portfolio as opposed to a single
investment. For instance, you may be curious about whether your portfolio of
stocks is doing as well as a mutual fund that has an investment objective similar
to yours. Or, you may be considering changing your strategy by shifting some of
your money to a different subclass of investment. In that case, you could
compare the returns for your current portfolio to the benchmark for the class of
investments you’re considering.

You should always keep in mind, though, that you can’t count on the market to
behave the same way in the future as it has in the past. These comparisons,
while a helpful way to evaluate your investment options, should not be
considered predictors of future performance.

Another important rule to keep in mind when measuring investment performance

against benchmarks is to examine returns over longer periods of time—ideally,
several years versus one year or one quarter. Short-term results can be
misleading because a particular company or fund may have a banner year or
suffer a slump in comparison to its benchmark. But these results may be due to
one-time events, which may be unusual and not a fair representation of the
investment’s performance over time.

On the other hand, the market as a whole could have an exceptionally good or
bad quarter in the midst of what’s known as a sideways market, where there’s
little long-term change. Benchmarking against an atypical quarter could give you
a skewed view of actual performance of a particular investment.

Finally, you’ll want to keep in mind that not all benchmarks are indexes or
averages. For example, the standard benchmark for long-term bond yields is the
yield of the 30-year U.S. Treasury bond.

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6. Reading Your Statement

Keeping track of your investments is important, but you might wonder how often
you should check on them. Some investors look at their portfolio values daily or
weekly, and if you own extremely volatile investments and have a short-term
investment strategy, that can be a good idea.

However, if your strategy is long-term, it’s important not to get overly concerned
with short-term fluctuations in value, since trading based on short-term volatility
could sidetrack your long-term goals and cost you money in taxes and
transaction fees. Instead, you may want to check performance monthly or
quarterly on the statements you receive from your investment accounts.

It’s important to read your statements before you file them away, both because
you need to know how you’re doing in relation to your goals and because you
need to see whether your statement is accurate, with all your trades accounted
for and recorded correctly.

If you have all of your investments in accounts with a single financial services
company, you may get a consolidated statement containing information about all
your accounts. However, if you have accounts at several firms, or if you have
both tax-deferred and taxable accounts, you may need to look at several different
statements to get a complete picture of your total portfolio performance.

In addition to sending you regular statements, many brokerage houses give you
24-hour access to your account information online, so you can look up the latest
values for your holdings any time you like. In addition, you may be able to access
your account information by phone or via an app on your smartphone.

Your monthly or quarterly statement will generally tell you the current market
value of your investments as of the closing date, the change in value since the
last statement and the year-to-date change. You’ll also see a record of your
transactions for the previous period, including purchases and sales, and
information on dividends, bond income and mutual fund distributions, as well as
realized and unrealized capital gains and losses. Some statements also show
projected earnings and provide pie charts showing how your portfolio is
allocated.

Most likely, your returns will fluctuate throughout the year, reflecting both the
fortunes of your particular investments and the ups and downs of the overall
market. This is where benchmarks can come in handy, so you can compare the

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returns in your statement with the returns of other investments. For example, if
the market is strong but your portfolio value is flat, that might be a sign for you to
look more closely at your individual investments. Yet if your portfolio slumps
when markets everywhere are falling, your portfolio may simply be reflecting
market conditions.

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7. Using Research

Another way to evaluate your investments’ ongoing performance is through

analyst research. Analysts at brokerage firms and at independent research firms
look not only at current performance, but also at future potential to give you a
picture of an investment’s strengths and weaknesses in the context of the wider
market. Analysts also recommend actions based on performance. The actual
language analysts use may vary, but in general, they recommend that you buy,
hold or sell an investment.

Whether you actually buy or sell based on an analyst’s recommendation is up to

you. Among other things, you should decide whether buying or selling a particular
investment is in line with your individual investing strategy. You should always
look at analyst research in the context of your own goals and your own
expectations for performance.

Furthermore, analysts don’t always agree with each other. As a general rule, they
also tend to give more positive than negative recommendations. If you’re using
professional research, it may be a good idea to read the recommendations of
several analysts to help you determine how an investment is performing and
whether you should make any changes to your portfolio.

With bonds, analysts don’t give buy, hold and sell ratings. Instead, they provide
credit ratings, which measure an issuer’s financial ability to meet its debt
obligations. If you’ve bought highly rated bonds, called investment-grade bonds,
you’ll rarely find the issuer’s credit rating changing dramatically enough to affect
your investment’s return. However, unless you’ve bought U.S. Treasury debt, a
lowered credit rating is always a possibility.

To keep current with your investments, you should also look at the reports issued
by companies relating to their financial situation and future prospects. For
example, companies that issue public stock must provide shareholders with
annual reports, and they must also file annual reports with audited financial
statements, known as 10-Ks, with the Securities and Exchange Commission,
which you can find online using the SEC’s EDGAR database at
www.sec.gov/edgar.shtml.

Companies also file quarterly reports with the SEC. You can use these reports to
evaluate corporate performance in more depth than you can manage by simply
checking prices and yields online. You might also want to keep in mind that the
annual report that companies send to shareholders, while easier to read than the
10-K, is usually designed to emphasize the positive aspects. The 10-K is plainer

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and more direct, and may provide insights you may overlook in an annual report.

Mutual funds also provide semi-annual and annual reports to help you track the
fund’s progress. The reports give you information about returns and fees, plus a
list of the fund’s holdings, so you can check the underlying investments that the
portfolio manager has chosen. By comparing these reports over time, you can
see how the fund’s holdings have changed. You should also compare the fund’s
results to the appropriate benchmark, to see how it fares next to its peers. Most
mutual fund reports provide this information, often in the form of a comparison
chart.

In addition, it’s very easy to set up online news trackers that will email you stories
on the companies, funds, industries and markets that you’re interested in. This
way, you can be on the lookout for news that might have an impact on your
investments, and provide you time to analyze the situation and decide what
changes, if any, to make to your portfolio.

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