Since the start of the year, the S&P 500 index has returned 0.4%, while the one-year return is 2.6% (we are talking about data from Bloomberg, dated October 25). An average growth portfolio (composed of 80% equities and 20% fixed income securities) would have returned 5 to 7% over the last five years, while a balanced portfolio (composed of 60% equities) equities and 40% fixed income) would post a five-year return of 4 to 5% (still as of October 25).
Despite this difficult stock market context – knowing that investing in the stock market pays off in the long term, but requires letting go and patience during certain periods – there is always someone in your entourage who will brag about the performance of their portfolio or their latest good move on the stock market. It’s the friend, the colleague, the neighbor, the brother-in-law who proudly proclaims that he “always makes 25% returns”, making you, therefore, doubt the effectiveness of your portfolio.
Obviously, it is possible to have in your immediate circle someone who is successful in the independent management of their investments or someone who is lucky enough to have nothing less than “the best investment advisor”. However, I would wisely hypothesize that we are not always comparing apples to apples here.
The importance of the concept of time
The return on an investment is generally presented over a period of time. Therefore, you must be absolutely careful when comparing returns over the same period. Typically, conversations near the coffee machine don’t even get to that level of detail. For example, someone can claim to have recently obtained a return of 25%, but do not take into account the losses assumed in the past, losses which would reduce the final return to date.
Let’s not hide it, it is also very plausible that the person who benefited from this enormous return will not give you any news if the same investment plummets or shows a substantial decline subsequently.
Thus, to talk about the return of a portfolio, we must take into account the return on all the securities held, net of fees. Even self-directed investors sometimes pay transaction fees. In theory, for self-directed investors, time spent on research and analysis — especially if it replaces time that could have generated other income — should be counted as expenses. This would then be a fairer comparison with the return net of fees of a portfolio on which management fees are taken.
Consider cash flow
The internal rate of return (IRR) is very useful since it allows you to calculate how much each dollar invested in a given period earns. It is more complex to calculate than time-based performance, which simply compares the market value of an investment at the end of the year with that at the beginning of the year, or any other period. For example, if the market value of the stock or fund you invested in increased from $10 at the beginning to $12.50 at the end of the year, you could say you had an investment with a 25% return.
However, this calculation does not take into account your precise reality. Calculated using the XIRR method, the IRR represents the net annual return for a given period and based on actual cash flows, such as all purchases of securities made during the period or withdrawals and sales to rebalance the portfolio or pay fees or transaction costs.
So, during the year, the security’s value may have increased temporarily to a price of $16. If this is when you invested part of your investments, your IRR is significantly affected downward. Consequence: for the same investment whose value has increased by 25%, the IRR could be negative, even when the security displays a positive return.
The moral of the story ? This knowledge that always makes 25% may exist, but without carrying out a rigorous analysis of all the data, do not suffer from a feeling of inferiority if your portfolio presents an annualized return net of fees of 6 to 10% on the last ten years.
There is no doubt that the conversations at holiday gatherings this year will be around the current economic and financial context. We will not escape the emotions that we have made the markets feel for two years. But you are now better equipped to put into perspective the performance claims heard around the punch bowl or holiday pie!