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Do you aspire to be a more successful investor? Then this article is exactly what you need to read today, as it explains the process of measuring one’s investment returns against various market benchmarks.
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There are multiple ways one can choose to try and assess the success rate of their investment. Among these, looking at generated returns has a top spot. That is one of the most basic and intuitive ways people can appraise the effectiveness of the tactic they are using. Then one can figure out the potential risk of their trades and the rewards linked to incurring them. Gauging the health of assets held lets individuals make more knowledgeable choices regarding how they manage their portfolios while aiming to stay on track to hitting their projected financial milestones. Hence, this process has massive value.
In short, benchmarking is a practice that entails investors stacking up the status of their stack of assets, often against a market index such as the NASDAQ Composite. Other market benchmarks include Barclays US Aggregate Bond Index, the Russell 2000, the Dow Jones Industrial Average, and the S&P 500. These metrics represent overall markets or specific sectors. They are handy tools that tell everyone if their portfolio is under or overperforming the market.
For instance, let us say that a portfolio shows an annual return of 10%. However, the market benchmark we are using has only risen by 8% for the same year. That means that group of assets has outperformed its industry by 2%. Note that this information is valid for more than the ranking of the success of these particular securities for the time being. It also serves as a guide as to what an investor should do with them in the future.
Below, we go more in-depth regarding measuring investment returns via benchmarks and the best ways to go about this activity.
Understanding Market Benchmarks
The simplest way to put it is to say that benchmarks are standards against which you can measure something. In investing, these are usually equity performance indexes. You can use them to analyze the risk, allocation, and returns of a given investment or batch of assets in a portfolio.
In the US, the most common index investors use for this practice is the S&P 500. Virtually everyone considers this best gauge of the overall well-being of the US economy. It is a market-cap-weighted index. What does that mean? It means that each stock’s weight is proportional to its market cap of the top 500 companies in the United States. As such, it provides an excellent representation of the country’s stock market and its financial sphere. That is so chiefly because it includes business entities from different industries.
The Dow Jones Industrial Average, on the other hand, utilizes the largest 30 blue-chip companies traded on the NASDAQ and NYSE (New York Stock Exchange). Unlike the S&P 500, this is a price-weighted index, where each stock’s weight is proportional to its price per share. That means the ones with a higher share price have a more significant impact on the index’s performance. Undoubtedly, the Dow Jones Industrial Average (DJIA) is the most famous price-weighted index. Entities such as Goldman Sachs and IBM have more influence on it than lower-valued stocks, such as, let us say, those from General Electric or comparable sector players.
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Lastly, The NASDAQ Composite is another market-cap-weighted index. It looks at every entity of the NASDAQ exchange. The NASDAQ is primarily home to companies from the technology field, essentially dominantly growing ones.
As we mentioned above, investors use these and other benchmarks primarily to compare the state of an investment. For example, they could be comparing a stock, ETF, or mutual fund to the overall market. If these are doing on par or better than the index they are comparing against, the general feeling is that they are doing well.
Measuring Investment Returns
Besides benchmarks, there are several other ways to measure investment returns. Firstly, one can look at totals, which give the most comprehensive overview since they include income and price appreciation. That means they also factor in interest and dividends. Calculate these by removing the value of the initial investment from the current one. Then pile on the income earned during the holding timeframe.
Then, there are annualized returns, which are the average yearly return. You can reach this sum by dividing the total return by the number of years you held an investment. Of course, you must also adjust for compounding.
According to many veteran financial experts, the risk-adjusted returns may be the most crucial of all when evaluating performance. This is because they account for the level of risk you took in a trade. You can figure this out by dividing the excess return, or the risk-free rate subtracted from the investment return, by the asset’s standard deviation.
It is paramount to periodically look at returns. Only in this way can you continuously track the performance of your individual investments and your portfolio as a whole. Then you can better spot when you need to rebalance so as to more swiftly reach your goals and manage risk better.
Absolute Returns vs. Relative Returns
Essentially, we have somewhat already covered these concepts in this article. Absolute returns measure the total loss and profit an investment has generated. Meanwhile, relative ones compare performance to a benchmark, like one of the previously discussed market indexes.
The formula for generating an absolute return on a trade is to subtract the initial price from the current one. Then divide this figure by the initial value. So, if someone has bought a stock for $100 and it is now trading at $120, its absolute return would be 0.2 because ($120 – $100) / $100 = 0.2.
The formula for getting the relative return is simpler. It just entails subtracting the benchmark return for the investment one. So, if a portfolio returned 10% in the last year, and the S&P 500 index produced a return of 12%, the relative one will be -2% because 10% – 12% is -2%.
Know that absolute returns do not factor in risk, while relative ones can dramatically get affected by benchmark changes. And they can be invalid in situations if you implement an inappropriate benchmark. Thus, both these metrics have their limitations.
Time-Weighted Returns vs. Money-Weighted Returns
These are two more methods of getting investment return appraisals. TWR, or time-weighted return, is a gauge that checks an investment portfolio’s compound rate of return over a distinct period. This method does not account for things like withdrawals, contributions, or outside cash flows. It isolates the investment decisions made from the influence of external sources. You can determine it by first figuring out the holding period return (HPR) for each sub-period of a held asset’s time horizon. Then utilize the geometric mean of the holding period return to compute the time-weighted overall one. The precise formula is [(1 + HPR1) × (1 + HPR2) × … × (1 + HPRn)] ^ (1/n) – 1, where n is the number of sub-periods.
Money-weighted returns factor in external cash flows. Their formula is (1 + IRR) – 1, where IRR is the internal rate of return, which first must get determined. Then one must equate the current value of cash inflows to the cash outflows. So, to put it bluntly, and concisely, TWR is an investment performance measure independent of outside cash flows. MWR, on the other hand, reflects the effects of external fund flows.
Evaluating Investment Performance Against Market Benchmarks
To compare investment returns to a defined benchmark, one must initially get data concerning accurate returns of their portfolio over a set timeframe. Then calculate the returns of their chosen benchmark over the same period. Naturally, then comes a comparison of these two figures to see how the portfolio has managed to do relative to the selected market standard (index).
While this procedure may seem simple on the surface, it requires an understanding of the context of the picked benchmark, how it has performed, and why. The same goes for the assets held in the compared portfolio for the chosen period.
Also, it is crucial to evaluate and pick the correct benchmark. A portfolio comprised of mainly large-cap US stocks should get put up against the S&P 500, with expectations of it performing similarly to this index. Moreover, you should not give short-term return fluctuations too much importance. That is on account of the fact that often they are not indicative of long-haul performance. It is vital that those who long to rake profits in the long term evaluate their investments over more substantial time horizons. The context and period over which returns get appraised are super essential to the measuring performance process. Do not forget that.
Measuring investment returns against market benchmarks is an essential investing practice. This is because it assesses the effectiveness of an investment strategy, identifies areas for improvement, and monitors a portfolio’s progress to reaching financial goals. Everyone needs to do some rebalancing now and again if they wish to remain on track with a healthy investment asset stack on hand.
Periodic adjustments are necessary for everyone. Only by properly evaluating the state of one’s portfolio is this possible. In that process, it is indispensable that investors have clear aims, pick an appropriate benchmark, and conduct analysis over suitable time frames. Without following through with these requirements, individuals cannot optimize their investments and are unlikely to hit their financial goals.
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