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Investment Performance Analysis - Simplified

By: Steve Selengut

It matters not what lines, numbers, indices, or gurus you worship, you just can't know where the stock market is going or when it will change direction. Too much investor time and analytical effort is wasted trying to predict course corrections--- even more is squandered comparing portfolio market values with a handful of unrelated indices and averages. If we reconcile in our minds that we can't predict the future, we can move through the uncertainty more productively.

Every December, with visions of sugarplums dancing in their heads, investors begin to scrutinize their performance, formulate couldas and shouldas, and determine what to try next year. It's an annual, masochistic, right of passage. My year-end vision is different. I see a bunch of Wall Street fat cats, ROTF-LOL, while investors and their alphabetically correct advisors determine what to change, sell, buy, re-allocate, or adjust to make the next twelve months behave better financially than the last. What happened to that old fashioned emphasis on long-term progress toward specific goals?

Let's simplify portfolio performance evaluation by using information that we don't have to speculate about, and which is related to our own personal investment programs. Issue breadth numbers, 52-week high/low statistics, and other market stats help you navigate the sea of uncertainty; Peak-to-Peak interest rate and market cycle analysis are more useful performance expectation barometers than the DJIA or S & P 500. When did it become vogue to think of investment portfolios as sprinters in a twelve-month race with an index?

Why are the masters of the universe rolling on the floor in laughter? They can visualize your annual performance agitation ritual producing fee generating transactions in all conceivable directions. An unhappy investor is Wall Street's best friend, and by emphasizing short-term results in a superbowlesque environment, they guarantee that the vast majority of investors will be unhappy about something, all of the time.

Your portfolio should be as unique as you are, and I contend that a portfolio of individual securities rather than a shopping cart full of one-size-fits-all consumer products is much easier to understand and to manage. You just need to focus on two longer-range objectives: 1) Growing productive working capital, and 2) Increasing base income. Neither objective is directly related to the market averages, interest rate movements, or the calendar year. They insulate investors from short-term thinking while facilitating objective based performance analysis that is less frantic, less competitive, and more constructive.

Briefly, working capital is the total cost basis of the securities and cash in the portfolio and base income is the dividends and interest the portfolio produces. Deposits or withdrawals and capital gains or losses, directly impact the working capital number, and indirectly affect base income. Securities become non-productive when they fall below Investment Grade Value Stock (IGVS) quality and/or no longer produce income. Good sense management can minimize these unpleasant experiences.

Let's develop an "all you need to know" chart that will help you manage your way to investment success in a low failure rate, unemotional, environment. The chart will have four data lines, and your portfolio management objective will be to keep three of them moving upward through time. Note that a separate record of deposits and withdrawals should be maintained. If you are paying fees or commissions separately from your transactions, consider them withdrawals of working capital. If you don't have specific selection criteria and profit taking guidelines, develop them.

Line One is labeled working capital, and an average annual growth rate between 5% and 12% would be a reasonable target, depending on asset allocation. This upward only line (Did you raise an eyebrow?) is increased by dividends, interest, deposits, and realized capital gains and decreased by withdrawals and realized losses. A new look at some widely accepted year-end behaviors might be helpful at this point. Offsetting capital gains with losses on good quality companies becomes suspect because it always results in a larger deduction from Working Capital than the tax payment itself.

Similarly, avoiding securities that pay dividends is at about the same level of absurdity as marching into your boss's office and demanding a pay cut. There are two basic truths at the bottom of this: 1) you just can't make too much money, and 2) there's no such thing as a bad profit. Don't pay anyone who recommends loss taking on high quality securities. Tell them that you are helping to reduce their tax burden.

Line Two reflects base income, and it too will always move upward if you are managing your asset allocation properly. The only exception would be a 100% equity allocation, where the emphasis is on a more variable source of income--- the dividends on a constantly changing stock portfolio. Line Three reflects historical trading results and is labeled: Cumulative Net Realized Capital Gains. This total is most important during the early years of portfolio building and it will directly reflect both the security selection criteria you use, and the profit taking rules you employ.

If you build an IGVS portfolio and diversify at 5% of cost basis, you will rarely have a downturn in this monitor of both your selection criteria and your profit taking discipline. Any profit is always better than any loss and, unless your selection criteria is really too conservative, there will always be something out there worth buying with the proceeds. Three 8% singles will produce a larger number than one 25% home run, and which is easier to obtain?

Obviously, the growth in line three should accelerate in rising IGVSI markets. The base income just keeps growing because asset allocation is also based on the cost basis of each security class--- get it? Note that an unrealized gain or loss is as meaningless as the quarter-to-quarter movement of a market index. This is a decision model, and good decisions should produce net realized income.

One other important detail: no matter how conservative your selection criteria, a security or two is bound to become a loser. Don't judge this by Wall Street popularity indicators, tealeaves, or analyst opinions. Let the fundamentals (profits, S & P rating, dividend action, etc.) send up the red flags. Market value just can't be trusted for a bite-the-bullet decision--- but it can help.

This brings us to Line Four, a reflection of the change in portfolio market value over the course of time. This line will follow an erratic path, constantly staying below working capital (Line One). If you observe the chart after a market cycle or two, you will see that lines one through three move steadily upward regardless of what line four is doing. But, you will also notice that the lows of line four begin to occur above earlier highs. It's a nice feeling since market value movements are not, themselves, controllable.

Line four will rarely be above line one, but when it begins to close the cap, a greater movement upward in line three (Net Realized Capital Gains) should be expected. In 100% income portfolios, it is possible for market value to exceed working capital by a slight margin, but it is likely that profit-taking opportunities are being ignored. Don't ever let this happen. Studies show that the majority of unrealized gains are brought to the Schedule D as realized losses--- and this includes potential profits on income securities. When a new high market value watermark is achieved, look around for a security that is no longer an IGVS and bite that bullet.

What's different about this approach? There is no mention of market indices, or comparison with anything other than your own objectives. This methodology will get you where you want to be without the hype Wall Street uses to create unproductive transactions, foolish speculations, and incurable dissatisfaction. It provides a valid use for portfolio market value, but far from the judgmental nature Wall Street would like. Its use in this model is as an expectation clarifier and an action indicator for the portfolio manager on a personal level.

Most investors will focus on line four out of habit, or because they have been brainwashed by Wall Street into thinking that a lower market value is always bad and a higher one always good. You need to get outside of the market value box if you hope to achieve your goals. Cycles rarely fit the January to December mold, and are only visible in rear view mirrors--- but their relationship with your new performance line dance is truly personal.

The market value line is a valuable tool, but that's all. If it rises above Working Capital, you are avoiding profits. If it falls, start looking for buying opportunities. If Base Income falls, you have altered the quality of your holdings or changed your asset allocation.

So, Virginia, it really is OK if your portfolio market value falls in a weak IGVS market or with upheaval in interest rate land. The important thing is to understand why. If it's a surprise, you don't really understand what's in your portfolio.
Isn't new information fun?

Article Source: http://articles.tiptopweb.info

Steve Selengut www.sancoservices.com www.kiawahgolfinvestmentseminars.com Professional Portfolio Management since 1979 Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire's Secret Investment Strategy"

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Investment Performance Analysis - Simplified addthis_pub = 'ex_plo_rer';

Investment Performance Analysis - Simplified