Imagine the following situation:
Mike’s retirement portfolio grew 30 percent during the year 2013. ritha’s retirement portfolio only grew by 8 percent in that same year.
Does this mean Mike is a better investor than Ritha? Not necessarily. But why not? In this article, we’ll explore how you can evaluate your investment returns within the context of your own timeline, goals and other individual factors.
Let’s start by looking at a hypothetical story …
Did Mike’s Investments Really Outperform Rhita’s?
Ritha North and her son Mike sat by the fireplace in January 2014, enjoying cups of hot chocolate and catching up on their lives.
Mike, a 27-year-old software engineer, was in a particularly good mood. He had just been reviewing the performance in his 401(k) plan. His account had performed exceptionally well in 2013, with a total return comfortably over 30 percent.
“How did you do last year, Mom?” she asked. Rhita, who — at age 64 — was on the verge of entering retirement, smiled. “Oh, just fine dear,” Rhita said. “Not nearly as exciting as your results, but just fine for your father and I.” Mike pressed further and learned that his mom’s 401(k) plan had gained just over 8% in 2013.
Then he remembered a similar conversation they had five years earlier, in February 2009, after Mike’s first full year of work. A look of puzzlement crossed his face.
“Ah, yes, you’re remembering a similar day five years ago, aren’t you?,” Rhita asked.
Ritha’s 401(k) only ticked slightly down in 2008, the year of the biggest stock market crash since the Great Depression. But Mike’s nascent retirement account suffered a loss of more than 50% that year.
Comparing Apples and Oranges
The story of Rhita and Mike underscores an important truth about assessing the performance in your retirement plan: you must compare apples-to-apples.
Comparing your performance to another plan, which is built around a different set of goals and risk considerations, is comparing apples and oranges.
Neither Rhita nor Mike is “doing better” than the other. They have different ages, timelines, and risk tolerances. As a result, they hold different types of assets in their portfolio.
Both of them need to evaluate their portfolios on their own terms. This is a two-step process. They must do a bottom-up evaluation of the performance of each asset class represented in their portfolio. They must also conduct a top-down review of the portfolio as a whole.
Bottom-Up Evaluation
What’s a bottom-up evaluation? Both the mother and son should look at the performance of each asset class, based on the individual funds represented in each class.
For example, Mike, who is younger and a more aggressive investor, may have three large cap U.S. stock funds, two small cap funds, one developed international and one emerging markets fund, and two intermediate bond funds.
He should compare the individual fund performance to a representative benchmark. The S&P 500 or the Russell 1000 can serve as a large-cap benchmark. The Barclays U.S. Aggregate Bond index is widely used as a benchmark for bond funds, and Morgan Stanley Capital International (MSCI) runs a wide array of international stock benchmarks.
Rhita, meanwhile, may only have a small allocation to large-cap U.S. stock funds, with the lion’s share of her portfolio in bond funds. She should compare each asset class against its relative benchmark, like the Barclays U.S. Aggregate Bond index.
If either both of them have actively-managed funds whose goal is to beat the benchmark, they is probably paying higher fees than they would for passive index funds. If the active funds are failing to beat their benchmarks, she’s not getting her money’s worth (which is usually the case).
If their funds in an asset class are not performing well against the benchmark, it is time to see if there are better options within your 401k plan.
Top-Down Review
In addition to the bottom-up review, it’s time to consider the performance characteristics of their total portfolio.
Portfolio performance is not simply the sum of each asset’s individual contribution. It also derives from how diverse assets interact under specific market conditions. In other words: Diversification adds real, measurable value to portfolio performance.
A person’s portfolio should be aligned with their goals and risk tolerance, and these factors will change as retirement draws near. That’s why mother and son had such different results in 2008 and 2013.
Mike had a higher allocation to riskier, growth-oriented assets. He has enough years left before retirement to recover from the risk of a steep downturn, like the one she experienced in 2008.
Rhita, who is much closer to retirement, had more safe-haven assets like bonds. That’s why she didn’t suffer as much from the crash of 2008, and also why her return was so much less than the stock market’s return in 2013.
When both of them conduct a “top-down” review, they should ask themselves: “How did my portfolio as a whole perform?” Then they should see whether or not their portfolio performed in-line with it’s design.
Rhita’s portfolio is designed to be more conservative, while Mike’s is designed to be more aggressive. If their allocation no longer fits their circumstances, they can modify their allocation to reflect their new situation.
No Free Lunch
In investment markets, as in life, there is no free lunch. Investors need to decide how much risk they’re willing to accept, in pursuit of a greater return. This trade-off is reflected in both of them portfolios.
Mike is right to have a higher slice of risky, growth-oriented assets — but he will have to endure some bumps along the way.
Rhita also has to make trade-offs. She will start drawing annual income from his 401(k) next year. She cannot afford to pursue as aggressive growth. But she still needs returns that can (at least) outpace inflation, and perhaps enjoy additional modest growth.
Remember, your 401(k) portfolio performance reflects your specific situation. It doesn’t matter how your portfolio compares to your dad’s plan, or your best friend’s plan, or your colleague’s plan.
What does matter? Two things: whether or not your portfolio is delivering the mix of growth and income that you’re targeting, and whether the returns are reasonable, relative to the mix of assets involved.
In short: Design your portfolio around your goals and risk levels. Then make sure you’re getting returns that are aligned with that design. And don’t compare yourself to someone who has a totally different set of goals and risk factors than you.
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