How Is Your Portfolio Really Doing?

Although the market has rebounded over the past few months, it's hard not to think back to a year ago, when your portfolio was no doubt worth a lot more than it is now.  

But before assuming that all of your past portfolio decisions have been wrong and undertaking radical changes, you owe it to yourself to put your holdings' performance into context.

If you've set up a portfolio on Morningstar.com's Portfolio Manager, you can use the Performance view to see your results graphed alongside the S&P 500; the My Performance tab enables you to look at your results alongside several other stock and bond indexes. (Read this article for a explanation of how to use the My Performance tab.)

But pure stock and bond indexes are pretty blunt instruments for evaluating your portfolio. They're mostly going to tell you whether your stock/bond mix has helped or hindered versus a portfolio composed entirely of stocks or bonds; they're not going to tell you how good your security selection has actually been. To do that, you need to evaluate your own returns alongside those of a customized benchmark that mirrors your own portfolio's allocation among stocks (both U.S. and international), bonds, and cash.

Setting up such a benchmark is simple and can be an invaluable way to evaluate whether changes are in order. If it turns out that your returns have lagged your benchmark (as well as stunk in absolute terms) over an extended period of time, then and only then should you think about undertaking changes. You may decide that rather than attempting to beat your benchmark, you're better off simply constructing a portfolio composed of inexpensive index funds.

Here's how to set up your own benchmark and use it to evaluate your performance.

Step 1: Check up on where you are now.
The starting point for creating a customized benchmark portfolio is to take a look at your portfolio's current positioning based on Morningstar's X-Ray tool. The beauty of X-Ray is that it drills down into mutual funds to see what they actually own--for example, if you own a stock fund that's holding cash, your asset-class distribution in X-Ray will reflect both cash and stock holdings rather than chucking the entire fund's allocation into stocks.

If you don't already have a portfolio stored on Morningstar.com, the easiest way to X-Ray your portfolio and save your holdings for future reference is to use Morningstar's Instant X-Ray tool. Enter the tickers for each of your securities (CASH$ if it's a CD or money market fund), then click Instant X-Ray.

You'll see your portfolio's allocation to equities, bonds, cash, and "other" (encompassing securities such as convertibles and preferreds), as well as its sector weightings and distribution within Morningstar's stock and bond style boxes. Take note of these distributions--in particular, the allocations to U.S. and foreign stocks, bonds, and cash.

If you want to save your portfolio for future use, click Save Instant X-Ray Holdings as a Portfolio at the top of the page.

Step 2: Set up a benchmark portfolio.
To create a simple benchmark portfolio that mimics your own portfolio in terms of its asset-allocation mix, calculate your exposure to each of the major asset classes--U.S. stocks, foreign stocks, bonds, and cash--in dollar terms. For example, if Instant X-Ray says that your portfolio contains 34% in bonds, 42% in U.S. stocks, 15% in foreign stocks, and 9% in cash, and your total portfolio is $1 million, your weightings would be $340,000 bond, $420,000 U.S. stock, $150,000 international stock, and $90,000 cash.

After that, click on Instant X-Ray from the Tools cover page of Morningstar.com. This time, start with a new screen for Instant X-Ray--separate from the screen where you entered your own portfolio holdings. Using index funds that correspond with each of the major asset classes, enter a new portfolio that reflects your own portfolio in terms of its asset allocation. (Enter "CASH$" for your cash holdings.)

Using the example above, the portfolio would consist of the following:

$150,000:  Vanguard Total International Stock Index (VGTSX) (Foreign Stock)
$420,000:  Vanguard Total Stock Market Index (VTSMX) (U.S. Stock)
$340,000:  Vanguard Total Bond Market Index (VBMFX) (Bond)
$90,000: Cash (CASH$)

Then click Show Instant X-Ray and Save Instant X-Ray Holdings as a Portfolio. Name this one "Benchmark Portfolio." (Note: I used Vanguard funds for the benchmark portfolio because the firm's international index fund includes emerging markets, but you could easily use similar index funds from other providers if you'd like.) 

Step 3: Make refinements if desired.
For simplicity's sake, I favor a streamlined benchmark portfolio with basic asset classes like the one I laid out above. If you want to fine-tune your benchmark portfolio to reflect your real portfolio, however, you can use other index funds or ETFs to reflect your asset mix. For example, if your portfolio includes a small slice of commodities, you could use the  iPath S&P GSCI Total Return Index exchange-traded note  to reflect your portfolio's real allocation to that area.

You could also further slice and dice your stock and bond exposure. To reflect positions in high-yield bonds or small-cap stocks, for example, you could use iShares IBOX High-Yield Corporate (HYG) or  Vanguard Small Cap Index (NAESX), respectively.

Step 4: Keep it current.
As you save both your own portfolio and your benchmark portfolio on the site, you'll notice that you have a choice between saving your portfolios as Transaction Portfolios or Watch List Portfolios. If you're not actively adding to or altering your holdings, Watch List Portfolios will be sufficient.

If, on the other hand, you make frequent changes or invest additional sums on a regular basis, you'll want to set up both your own portfolio and your benchmark portfolio as Transaction Portfolios. By entering additional sums invested as well as any changes you've made and adjusting your benchmark portfolio accordingly, you'll be able to track your portfolio's returns with precision.

Step 5: Use it to gauge performance.
Your benchmark portfolio will help you gauge your portfolio's performance in the years ahead and also get your arms around your portfolio's biggest drivers. It can also enable you to check up on how you've performed in the past, particularly if you haven't made big changes to your portfolio over the past several years.

To compare your portfolio's performance with that of a benchmark portfolio over various time periods in the past, click on the Tracking tab within Morningstar's Portfolio Manager tool. Then click on Performance. Adjust the time period to reflect your own holding periods. (The graphing function is limited to the past three years.)

In addition to helping you determine how your portfolio has performed, this exercise can also help you see how closely your portfolio has tracked a simple index-based portfolio over time. If you find that your portfolio's return lands in close proximity to that of your benchmark, that could be an indication that you're not adding value with security selection and may be better off keeping it simple by using a portfolio of inexpensive index funds.

A version of this article appeared on July 10, 2008.

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