Develop a comprehensive method for monitoring and evaluating portfolio performance over time, ensuring it aligns with set goals and adjusting the strategy accordingly to maintain long-term objectives.
Developing a comprehensive method for monitoring and evaluating portfolio performance is crucial for ensuring your investment strategy remains aligned with your long-term objectives. This process goes beyond simply looking at your portfolio’s total return. It involves tracking performance against specific benchmarks, measuring risk-adjusted returns, and regularly reviewing your strategy to make necessary adjustments based on performance, market conditions, and changes in personal circumstances. A well-structured monitoring and evaluation process enables you to identify any areas of your portfolio that are underperforming and allows you to proactively make adjustments to ensure long term objectives.
The first step in this method is to define clear, measurable investment goals. These goals should be specific, with clear time horizons, and clear benchmarks for success. Instead of just having a general goal such as "save for retirement," set specific goals such as "accumulate $2 million for retirement in 25 years." This should be coupled with smaller, short-term milestones, that can be evaluated along the way. For example, saving $50,000 in 3 years, or achieving a specific rate of return in each year, can be used to track progress. With clearly defined goals, the performance of the portfolio can be tracked in alignment with its objectives, rather than only against general market returns. These goals must also take risk tolerance into account, as it is not sufficient to simply achieve high returns at any cost.
The second step is to establish appropriate benchmarks. These benchmarks will act as a yardstick against which your portfolio’s performance is measured. Benchmarks can vary depending on the asset classes in your portfolio. For instance, if a significant portion of your portfolio is allocated to large-cap US stocks, the S&P 500 index can be a good benchmark. If you have exposure to international equities, a relevant international index should be used. For fixed income, the Bloomberg Barclays Aggregate Bond Index, or a similar bond benchmark can be used. Using relevant benchmarks will provide a better view of performance compared to generic market returns. If you are in a high growth strategy with smaller cap stocks, your benchmark should be aligned with that as well. Also, consider using more than one benchmark, to give a broader view of overall performance.
The third step involves tracking key performance metrics regularly. This includes calculating total returns, which is the overall increase or decrease in the value of your portfolio over a specific period, as a percentage of the initial investment. Tracking absolute returns on their own is insufficient, as they do not take risk into account. Therefore, it's also crucial to calculate risk-adjusted returns which will provide a more complete picture of the portfolio’s performance. The Sharpe ratio is a common metric that measures returns in relation to risk, by calculating excess return for every unit of risk that was taken. The higher the Sharpe ratio, the better the risk-adjusted performance. Tracking maximum drawdowns, the largest decline in value of the portfolio, is also valuable for evaluating downside risk. Tracking metrics such as standard deviation, alpha, and beta can also give a better overview of overall portfolio performance. For example, if a portfolio has had a 12% overall gain, but that gain came with higher volatility, and more risk, the Sharpe ratio may be very low, and would be cause for concern.
Fourth, assess the performance against your set goals and benchmarks. Regularly compare your portfolio’s performance against your predefined financial goals. If your portfolio is consistently underperforming its benchmarks, or lagging in progress towards your goals, it’s a clear indication that adjustments are needed. If your financial objectives include generating a specific amount of income in retirement, or a specific target in your portfolio, and you are not on track to achieve that, then changes to strategy may be needed. It may also indicate that your initial goals were not realistic or require adjustments.
Fifth, conduct periodic portfolio reviews and adjust the strategy as needed. A review should be conducted on at least an annual basis, or more often if necessary, due to market conditions, or life changes. This involves a detailed analysis of the current asset allocation, diversification, and overall performance. If your asset allocation has drifted away from your targets, a rebalancing is necessary to bring the portfolio back in line. Similarly, if you find that your initial assumptions about certain assets no longer hold true, you might need to replace them with new investments, or change your overall allocation. A review is not an automatic process but rather an opportunity to reflect on the past and make strategic changes for the future.
Sixth, factor in changes in personal circumstances. Your risk tolerance, time horizon, and financial goals are likely to evolve over time. Major life events such as marriage, having children, starting a new business, or approaching retirement can impact your investment strategy. The portfolio should be reviewed every time there is a significant life change. For example, if your risk tolerance has decreased as you approach retirement, it may be necessary to reduce exposure to more volatile assets such as stocks, and increase allocations to safer assets like bonds. If you are further away from retirement, you may be able to have a higher exposure to equities to take advantage of long term growth opportunities.
Seventh, maintain a long-term perspective, and avoid reacting to short term market fluctuations. Short term market volatility can trigger fear and emotions, which can impact decision making. It is very important to focus on the long term goals, and not be swayed by short term market moves. While adjustments to strategy are necessary, they should be based on objective performance analysis, and long term financial goals, and not on a reaction to short-term market noise. It may be best to take a break from viewing portfolios when markets are extremely volatile, to avoid any emotional decision making.
Finally, it is useful to document all of the steps in the process, to keep track of how, when, and why, strategic changes were made to the portfolio, and to the investment strategy. This can be invaluable when reviewing historical performance, and will give you a better view of what changes were successful, and what changes did not yield the desired results.
For example, if an investor initially targets a long term growth portfolio with a higher allocation to equities, they may use a benchmark such as the S&P 500. Over a 3 year period, if the portfolio underperforms the benchmark, and their progress toward their financial goals is lower than expected, this would signal a need for evaluation. They would calculate the Sharpe ratio, and find that their risk-adjusted returns were very low. This would cause them to make several adjustments, such as rebalancing the portfolio, reducing the allocation to high volatility stocks, or adding different asset classes to improve the risk adjusted returns. They would continue to track results of these changes, until they are back on track with their long term objectives.
In conclusion, monitoring and evaluating portfolio performance is an ongoing process that requires a disciplined approach. Setting clear goals, using appropriate benchmarks, tracking key performance metrics, conducting regular reviews, accounting for life changes, and documenting decisions all contribute to a well-managed portfolio that is aligned with long-term objectives. This comprehensive method will ensure you remain on track to meet your financial goals, while managing risks along the way.