Performance
There are some professions where you cannot make a mistake. A trapeze artist is one of them. What this performer is doing is amazing. Graceful and balanced. It is a risky situation to be in. There is no safety net underneath her. She must perform flawlessly. Perfectly. Every time.
Fortunately for the rest of us, investing does not require the extreme discipline and accuracy of the trapeze.
Investing is not precise. It is not perfect. Your life is not going to depend on every decision you make. Unlike the trapeze artist, you do not need to get it right every time.
In this article we are going to learn about a different type of performance. Investment performance. When we talk about investment performance, we are talking about returns. How do you know how well your investments are performing? What are my returns?
Understanding performance is a concept you use every day. It is about comparing something to something else. How do I compare one fund versus another fund?
“Apples to apples” is a good analogy. Within the apple group is a very long list of different types of apples. I’m not an apple connoisseur but for those who are, subtleties like taste, color, smell, and crunch factor are important characteristics when choosing an apple.
The same is true in investing. When you decide to invest in a fund, how can you compare one fund against the other.?
One of the ways to distinguish one fund from another is by comparing the performance of funds that have similar strategies and use similar securities (stocks and bonds).
So where do you start? You start with a point of reference. In the investment world the point of reference is called a benchmark or index. I think of indices and benchmarks as landmarks. They guide you when you are not sure what direction to take. One of the most widely used stock indices is the Standard and Poor’s 500 Index. The S&P 500 index is a list of 500 companies in the United States.*
Every day the final stock prices for each company determines a single performance number for the index. When you hear someone say, “what did the market do today” what they usually mean is: “what is the performance return today for the S&P 500?”
The point is this: If you as an investor want to buy a fund that replicates the performance of the S&P 500 index, you will want to know if the fund you have invested in is doing better than, or worse than, the index.
In the following video I am going to show you how to compare the performance of a fund to the benchmark or index.
Compare Fund Performance to Benchmark or Index
You have now seen that performance is compared in percentage terms. The index, or benchmark is your reference point. You will compare the performance of stocks, bonds, and funds to the reference point AND to similar funds.
There is another benefit from knowing what an index is and what performance is. The benefit is a reality check for expected returns. And a reality check on your expectations for returns. In the video we see that the 10-year return of the S&P 500 is 10.86 %. Funds that are designed to replicate the S&P 500 should not have wildly different returns.
Here is the thought process: I want to invest in a very broad stock fund. One that encompasses many of the stocks I would like to own but are too expensive for me to buy as an individual. I know that the S & P 500 index is a good benchmark for returns. However, I am seeing several funds that use the S&P 500 as the benchmark, but the returns are not similar. In fact, one fund has twice the returns of the S&P 500. I wonder if this is a better fund?
If you actually see a fund that has double the returns of the S&P 500, something else is going on. Higher returns signal higher risk. Until you are ready to do some digging the performance discrepancy is a red flag. This is more of an apple to oranges situation.
I’m not saying don’t take risk. One of my colleagues was fond of saying “you can manage the risks you know you have, you cannot manage the risks you don’t know about.”
I might say: “don’t get on the trapeze if there isn’t a net to catch you.”
There are other factors that you can use to compare funds, but I believe performance is a good place to start.
*The Standard & Poor’s 500, often abbreviated as the S&P 500, or just the S&P, is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices. It differs from other U.S. stock market indices, such as the Dow Jones Industrial Average or the Nasdaq Composite index, because of its diverse constituency and weighting methodology. It is one of the most commonly followed equity indices, and many consider it one of the best representations of the U.S. stock market, and a bellwether for the U.S. economy. The National Bureau of Economic Research has classified common stocks as a leading indicator of business cycles. https://en.wikipedia.org/wiki/S&P_500_Index
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