Physician Investing Mistake: Too Much Focus on Returns

October 6, 2014

Trying to compare your investment returns to any given benchmark can be misleading and lead you down the wrong path.

Occasionally I am asked, “What kind of returns do you get on your investments?” My answer is, “That depends.”

Every family has a different portfolio and a different set of cash flows. Figuring out an investment return is therefore a very individual process not applicable to anyone else. Since most fee-only advisers use predominantly low-cost diversified portfolios, most of their “investment returns” will reflect the returns of the markets they invest in for any given time period.

It is also confusing to answer this question due to the difference between what is called the “time-weighted return” and the “money-weighted return” of a portfolio.  The time-weighted return is how the portfolio did given a specific time period with no change such as money being added or subtracted. Time-weighted return is not a bad way to evaluate a given asset allocation, but may have little to do with “real” individual returns.

The money-weighted return (sometimes called the internal rate of return) takes into account the timing and amount of cash flows in the portfolio during the time of measurement.

Let’s examine the difference. Take a portfolio that appreciates 20 percent in year one and then drops 20 percent in year two. If you start with 100 dollars, you have 120 dollars at the end of year one, and then 96 dollars at the end of year two. Your time-weighted return is negative.

If, however, you withdrew $50 at the end of the first year (leaving $70), then only the $70 would be exposed to the 20 percent drop, leaving you with $56 in the portfolio and $50 in cash. Your money-weighted return for the same time period is positive. Same portfolio, same time period, different cash flows and therefore a different return. The differences between time- and money-weighted returns can be significant. Which do you want to know?

I will strongly argue that paying attention to “returns” in a long-term portfolio may be a mistake. For any given asset class, a stable amount of cash should presumably return a similar amount as the benchmark (such as the S&P 500 Index for appropriately similar investments). If not, you may be exposed to poor active management or large expenses (or both).

However, if you have a low-cost diversified portfolio, trying to compare your returns to any given benchmark is misleading and inappropriate other than in comparing the gains/losses to your individual goals.

Personally, for both myself and my clients, I do not pay attention to “returns.” I keep broadly diversified and low-cost portfolios that are individually designed to fit the long-term goals and risk tolerance of each family. We periodically rebalance either with existing or new funds. Every now and then a particular asset class looks either inexpensive or too expensive, and we adjust the portfolios accordingly. Then we wait. I’d suggest you do the same.