Measuring Past Performance — Improve Future Performance

By Ken Hawkins

Opening my monthly investment statement, I wondered… how is my portfolio really doing? I was interested in knowing the absolute performance number because I know I need to average about 6% per annum in order to reach my financial goals. I was also interested in a relative number – how was I doing compared to the stock market index – would I be doing just as well if I simply bought an Exchange Traded Fund?

Of course no matter how hard I looked, I couldn’t find the one number I was looking for. No where to be found was the rate of return my investments earned over the last month, quarter, year, or last five years. Most financial institutions just don’t want to show clients how they’re doing compared to the appropriate benchmark. When I first started investing 30 years ago, that information was not available, and now in 2006 the performance information is still no where to be found on my statements. For the last 10 years my company has been saying this information is a priority but it never appears.

Performance Measurement Provides Important Feedback

Past and current performance statistics is vital information. If an investor can't keep score of their actual return, they can’t know if they're on track to achieving their goals. With poor performance maybe the investor should be spending less, or with better than expected performance maybe he or she could be spending more – or moving to a lower risk – lower return portfolio. Also, without performance measurement how does one know if adjustments should be made – let alone what type of adjustments should be made to their investment strategy?

Receiving proper feedback is important not only in achieving ones financial goals but also in goals related to school, employment, personal relationships, sports and almost everything. If you wouldn’t drive a car without headlights and a speedometer you shouldn’t invest without measuring performance and comparing actual results with a reasonable benchmark.

It is well established that providing proper feedback on performance causes the performance to improve. Our whole learning and education system is designed around providing students with proper feedback on their performance by using report cards and evaluations. In the workplace, employee evaluations are an important process, providing feedback to the employees with a goal to rewarding good performance and to improve performance in the future. In business the results of marketing or advertising campaigns are measured against minimum acceptable standards of performance. Strategies that don’t work (and the managers who promote them) get shelved. It should be the same with your investment strategies.

It is clear that the act of measuring performance can by itself contribute to better future performance. According to a study of over 3,000 people in weight loss and weight maintenance programs conducted by researchers at the University of Minnesota, daily weighing is an effective strategy. Of those studied, 20 percent reported never weighing themselves, while 40 percent said they weighed themselves daily or weekly. Those who weighed in daily lost 12 pounds on average versus an average of 6 pounds for those who weighed themselves weekly; while those who skipped the scale gained 4 pounds on average. The daily weighing helps alert people that they're heading into the "red zone" of gaining more than five pounds. If someone notices early that they're on a weight gain trend, they can take immediate steps to stop the weight gain.

With investing the ‘daily’ weighing is replaced with a monthly ‘weighing’ or measuring of performance. How much (in percentage terms) did you gain or lose, and how does this compare with the benchmark? (See note below for a discussion of benchmarks)

In most aspects of our lives the regular measurement of performance helps us to make the changes necessary to improve performance. This is also true in investing and with investing a small improvement, as little as 1% per annum, can often mean retiring one or two years sooner.

Professional Investors Know the Importance of Performance Measurement

In the world of the institutional investors, where professionals manage hundreds of millions of dollars, performance measurement is an important part of their ongoing investing process. It would be unheard of for professional managers to go to a meeting with their client and not have all of the relevant performance benchmarks close at hand. The performance numbers are crucial as they help shape their investment policy and adjust their investment strategies. They are critical because:

  1. The rates of return that their investments earned are used to determine if they are on track to meet their long term goals.
  2. The performance measurements help determine which investment strategies worked or did not work, and why they might not have worked. Adjustments can be made to the strategies to correct problems that might have existed and additional funds can be moved to those strategies that were successful.
  3. The performance numbers are also important in making decision on the retaining, hiring, and firing of investment managers. Those who are able to consistently add value will be retained and those managers who consistently do poorly will be fired.
  4. Performance numbers are also an important part of an investment manager’s compensation. Performance that exceeds the benchmark is rewarded with bonuses, providing powerful incentives to outperform.

Individual Investors Can Benefit From Performance Measurement

For the individual investors, the same logic applies.

  1. Performance numbers provide essential feedback on the effectiveness of their current investment strategy and the quality of the advice they receive.
  2. Monitoring the performance and understanding the reasons behind it allow investors to determine if they are on track to meet objectives.
  3. Monitoring performance against a benchmark may show if one’s assumptions about risk and volatility are correct.
  4. With proper performance measurement, the investor can make adjustments to their holding or strategies, retain or redeem mutual funds, and to retain or fire their current advisers.
  5. On the topic of firing advisors, investors who manage their own money and consistently under perform against a benchmark might want to reconsider whether or not they need some professional advice.

Will providing performance statistics help individual investor do better in the future? For those investors who will ignore the numbers, more numbers are not going to help. However, those investors who use the numbers to gain understanding of how the performance was achieved, and then use this information to make sensible adjustments will benefit enormously by having performance statistics.