Clark Wealth Management Group - ScotiaMcLeod Fredericton

This is the time of the year when many look back and take stock of what progress they have made toward their financial goals in 2011. This process typically involves a review of the performance of any investments over the period. Most often this performance is measured as a percentage gain or loss.

Happy investors have had a positive return on their investments over the past year. The higher the positive number the better. The happiest investors have made more money than most. That is, they’ve outperformed whatever it is they’re measuring against. This is known as ‘relative performance’.

The more formal definition of relative performance is: the performance of an investment against an index, sector or a defined peer group expressed as a percentage.

We use relative performance to measure many things in life. In school for example, if a student’s mark is 84% while the class average is 64%, that student has outperformed by 20%.  The police use it all the time to identify motorists who outperform the benchmark, the legal speed limit.

So if relative performance is not a foreign concept, why do some investors have so much difficulty grasping the concept – particularly when the numbers turn negative?

Making relative performance of your investment portfolio a useful management tool requires a couple of steps. The first step is to identify what it is you are going to use as your benchmark.  A benchmark is just a standard or point of reference against which things may be compared. It’s important that the benchmark you use be appropriate for the portfolio you own.

For example, if you were a judge at a dog show, you would need to compare the entrants against other dogs (preferably the same breed) to determine the best. Comparing dogs to some other animal species would make no sense at all. This common sense approach applies to selecting investment benchmarks. If you own a Canadian equity mutual fund, you would need to benchmark it against a group of Canadian equity mutual funds or a Canadian equity market index. Comparing it to current GIC rates would make no sense at all.

The second step in making benchmarks more useful is to apply the same relative comparison to positive and negative returns. Any investor will be pleased if a Canadian equity mutual fund they own returned 10% last year while most other similar funds returned 5%. They’ll know right away that their investment has outperformed by 5% and believe the manager did a great job.

When the numbers go negative though, things get weird. Let’s say for example that your Canadian equity mutual fund lost 5% last year while the benchmark lost 10%. Many investors will be downright ticked off that the manager lost 5% of their money. Wait a second. This manager has outperformed his benchmark as well – by the same 5% as the one who outperformed in rising markets.

I get it. People want to always have a positive return, even if they own investments like Canadian equity mutual funds or bank stocks or (insert investment of your choice here) that sometimes go down in value.

Just as the law of gravity affects everything, when markets we invest in go up or down, our investments in those markets will generally do something similar. When they go up we hope to go higher and when they go down we hope to go down less – but to a large extent that is not something an investor (or their advisor) can control or anticipate.

What can and must be controlled by investors is how their important money is invested across all the various types of investments. That’s risk management by diversification and asset allocation. Those are topics for another day. 

Keir Clark, is a senior wealth advisor, with Clark Wealth Management Group, associate director wealth management and branch manager at ScotiaMcLeod in Fredericton, NB. He can be reached online at www.keirclark.ca or by telephone at 506-450-6465.

Information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, expressed or implied, is made as to the accuracy or completeness.