Investing your money is a key part of building wealth over time. While there is an inherent risk in any investment, it’s important to understand how your investments are performing and whether they are on track to meet your financial goals. Measuring the success of your investments helps you determine if you need to make any changes or adjustments to your investment strategy or portfolio allocations to maximize your returns and reach your key milestones.
In this article, we will explore several ways to evaluate the performance of your investments so you can gain insights into their success and progress. Monitoring your investments closely and making data-driven decisions can help ensure your hard-earned money is working as efficiently as possible for you.
Establish Your Investment Objectives
Understanding your financial objectives and risk tolerance is essential for defining and measuring investment success. Before tracking any metrics, you must first determine what success means for you personally based on your goals and priorities.
Are you seeking high returns to build wealth over the long term? Or do you prioritize generating a steady income stream? Alternatively, preserving capital and minimizing losses may be your main focus. Different investment goals point to different success criteria.
Aggressive growth investors may look primarily at total returns as the best gauge of performance. In contrast, conservative investors for whom downside protection matters most will focus on risk measures like volatility and maximum drawdown.
Track Your Principal And Returns
At a basic level, you need to measure how much your actual investments have earned or lost in both principal and returns over time. Determine how much you contributed in total and how much is in the account currently. The difference between those two amounts represents your gains or losses. For more details, review monthly or annual statements to see the change in value based on both contributions and returns. Make sure your money is growing at a decent rate over the long run based on your investment minimums.
Adjust The Risk On Returns
Returns alone do not tell the whole story of an investment’s performance. The level of risk an investor took on to achieve those returns is just as important. Higher-risk investments must generate proportionally higher returns to justify their increased volatility. Otherwise, lower-risk options that produce similar returns would represent better risk-adjusted performance. Risk-adjusted return metrics account for an investment’s volatility, isolating the returns attributable solely to the investor’s selection and decisions, not just overall market movements. This provides a fuller understanding of how well an investment is performing for the risk assumed and allows investors to more accurately compare the risk-return tradeoff of different options.
Use Performance Ratios To Benchmark Returns
Popular performance ratios include the investment return on investment (IRR) and return on investment (ROI). The IRR refers to the annualized return of your investment over time. For example, an IRR of 8% means your investment is yielding an average of 8% per year. The ROI is the total return divided by the average investment. If you earn $800 in returns over ten years on an average investment of $10,000, your ROI is 8%. Compare your IRR and ROI to the average returns of similar investments to determine if you are achieving decent performance. For stocks, aim for an IRR of at least 7% annually. Measure both short-term and long-term returns.
Growth Of Capital
For investments that change in value over time like stocks, bonds, and real estate, monitoring the growth of your initial investment can indicate how successfully the investment is performing. By tracking the total change – both positive and negative – in the dollar value of the investment, you can gauge its ability to generate returns that compound and build wealth over the long run. Even modest gains that are reinvested and compounded year after year can translate into significant accumulations of capital over decades. Therefore, assets that appreciate steadily in value, outperforming inflation and market indexes, on the whole, represent the most successful investments.
IRR vs ROI
While both are measures of investment return, there are a few key differences between IRR vs ROI. IRR considers the timing and amount of your contributions and withdrawals to determine your annualized return. ROI simply divides your total profits by the average investment amount. IRR also accounts for compound interest, while ROI does not. For most investors, IRR presents a more accurate picture of your investment’s performance over time. However, when used together, IRR and ROI can provide valuable insight into how your money and investments are performing.
Consider Risk-Adjusted Ratios For Accurate Comparisons
When comparing returns across different investments, it is important to consider risk-adjusted ratios as well. The Sharpe ratio measures return versus risk, calculated based on the excess return you receive over the risk-free rate of return per unit of risk taken. A higher Sharpe ratio indicates a better return for the level of risk. The Treynor ratio is calculated based on excess return over the beta, which measures market risk. These risk-adjusted ratios provide more meaningful comparisons across investments.
Benchmark Your Results Against The Market
Monitor standard benchmarks like the S&P 500 index to determine if your investment performance beats the overall stock market. While the stock market has averaged 7% (adjusted for inflation), top investors achieve even higher returns over time based on a solid investment plan. However, do not get discouraged if your investment underperforms in any given year. Stay focused on your long-term strategy and make progress toward your goals. With time and patience, achieving market-beating returns is possible with a well-diversified portfolio.
To Wrap Up
Successfully measuring the performance of your investments relies on tracking a few key metrics over time. Returns, risk-adjusted returns, capital growth, and diversification are all important financial factors to monitor. But ultimately, investment success means your portfolio aligns with and supports your personal financial goals.
Regularly evaluating your investments using measurable benchmarks provides valuable insights into whether your strategy needs adjusting to better achieve those goals. With the right tracking and performance metrics in place, you can make more informed decisions that optimize the success of your portfolio in the long run.