May 15, 2007

How to be a better investor – evaluating performance

One of the most important aspects of becoming a better investor is to evaluate one’s performance. However I do not think an absolute performance is the right way to do it.

For ex: If one’s stock portfolio returned 2% during the period 2000- 2003, I would consider it to be a superior performance than a 30% increase from 2003-2006. The reason is that during the period 2000-2003 , the market lost more than 30%, whereas during the period 2003-2006 the market almost doubled.

I evaluate my own performance as follows

I use the following formulae to evaluate the performance on my stock portfolio. I am not referring to a single stock, but for the entire stock portfolio.

Return = End portfolio amount – starting portfolio amount – cash added (or removed)/ starting portfolio amount

The period for the above formulae can be a month, quarter or a year. I prefer to evaluate the performance annually.

I compare this performance with the following three benchmarks. You can look at these benchmarks as three rising levels of hurdles to be crossed.

Level 1 – No risk FD return – This is the return I get from investing in bank FD. The stock portfolio has to cross this level. Otherwise I am way better off investing in FD’s and going off to sleep.

Level 2 – Index fund return – This is the return one can get by investing in the index (NSE or BSE) via ETF’s or index funds. The stock portfolio has to outperform this level, other wise I am better off investing in an index fund.

Level 3 – Mutual fund return – I referred to it in my previous post. My stock portfolio return should exceed the return I get from my portfolio of mutual funds (post expenses). If not, then I am again better off handing my money to the fund managers and doing something better with my time.

A caveat – One should not make a decision based on a single year’s return. In a single year, the stock portfolio returns can be volatile and even be below level 1 benchmark . I prefer to look at rolling 3 year returns to reach some tentative conclusion. I would prefer to look at the results of atleast 5 years before reaching a conclusion that I have crossed each of the above benchmarks. For a 5 year period, one should look at the cumulative returns from the stock portfolio and compare it with the above 3 benchmarks. Only if one has done substantially better than the three benchmarks, can one conclude that he or she ‘may’ be a superior stock picker.

The above may sound harsh and pompish. But I think if one has to be better investor, honest appraisal of one’s performance is important. If I have five duds and my portfolio returns less than what I could get in an FD, then there is not much to be gained from a stock pick which doubled in 15 days. I may have bragging rights and may feel smart, but I am not being honest and objective about my performance.


h# said...

Thanks Rohit for sharing your views on evaluating one's performance. I have a question though on the formula, as you are just deducting the "Cash added/removed" part. Now if you are looking at a period of a month then this should be fine, but for a 1 year period cash added/removed in say the middle of the year might change the annual return figures drastically. any views on that?

h# said...

Also, at the end of evalutation period will the value of the portfolio include paper profits as well? because unless you book these profits they might never happen.

Rohit Chauhan said...

yes, when you add cash and have gains on it, it inflates the returns and vice-versa.
on second question, i consider the value of the portfolio. that includes the realized and unrealized gains.
i am not sure what you mean by booking profits as they might never happen ... i sell a stock only if the price is above the intrinsic or something is wrong with the fundamentals. so it doesnt matter if the profits are booked or unrealized. if your analysis is good, then selling should happen based on multiple factors in addition to the paper profits