The Market Commentator has a question for you.
If a family member or close friend asked how your investments were doing, what would be the basis of your answer? Would your answer be based on the income you are receiving on your investments, or on total return? Would your answer be based on what results you have experienced as of late, or over the long term? Would you also consider how confident you are in your investment approach, or how much you worry about what the future holds? Would taxes factor into your answer? How about inflation?
As the foregoing questions imply, an evaluation of an investment portfolio’s performance involves all of these considerations. In the upcoming weeks, The Market Commentator will try to shed some light on the various metrics that come into play when evaluating a portfolio’s performance. More specifically I will be discussing:
- Whether investors should put greater emphasis on yield or total returns when deciding how to invest.
- The role risk plays when evaluating portfolio performance.
- The impact of taxes on returns.
- Should the social good (or harm) of a portfolio’s investments be considered?
- Comparing a portfolio’s performance to a benchmark.
This week I will be discussing why individual investments that lose money in the short term can actually lead to higher portfolio returns in the long term.
Winners vs. Losers.
In the 1950’s, Professor Harry Markowitz of the University of New York proposed a new approach to investment management that became known as Modern Portfolio Theory. Before then, investors tended to focus on the performance of the individual investments that made up a portfolio. Professor Markowitz used mathematics to demonstrate that investors should instead concentrate on the expected return of the portfolio as a whole over the investor’s individual investment horizon.
Professor Markowitz and his colleagues also demonstrated that investment portfolios that are comprised of securities that tend to move in opposite directions (i.e. those that are negatively correlated), are likely to out-perform portfolios of securities that commonly move in the same direction, (i.e. those that are positively correlated). They demonstrated that a well-diversified portfolio (that is, a portfolio that includes negatively correlated investments) is more stable than a portfolio that is concentrated in investments that tend to perform alike. This is especially true in down markets. As a result, over time an investment portfolio that holds some securities that are underperforming the market (“losers”) and others that are outperforming the market (“winners”) can be expected to generate higher returns than a portfolio where all of the investments are “winning” at a given moment in time.
In sum, a short-term decline in the value of a given security that is included in an investment portfolio should be of little importance when evaluating the portfolio’s performance. What truly matters is the impact each investment in a portfolio is expected to have on the portfolio’s return over the long term.
My next blog post will discuss alternative ways to measure an investment portfolio’s performance. I hope that you enjoy this series of blogs. Please use the comment box below to let me know if you have questions or comments about anything you read in any of my posts, or if you have suggestions for future posts. I look forward to hearing from you!
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