In most conversations with new clients or prospective clients the subject of performance invariably arises. Whether it's related to the prospects for income generation or the comparison of one investment to another, the return that can be expected on a portfolio is among the top concerns for individuals. Most people want an idea of what their money will earn in income as well as the prospects for increases in asset values. It's very easy to look up returns on mutual funds and indexes and use them as a base for comparison. The problem with comparing performance numbers to an index, or to some other investment vehicle, is the timing of the asset purchase, whatever it might be.
You can easily compare the performance of any stock, ETF, mutual fund or securities portfolio to the S&P 500 Index. The issue remains that you can't actually buy the index. You can buy a proxy for it like the Vanguard 500 Index fund. This is not the same thing. Let's say the S&P 500 Index goes up 10% year-to-date. This means since January 1st (actually January 2nd since the first is always New Year's holiday) the index is up 10% and this assumes you bought it on January 1st. If you don't sell you haven't actually made anything except for a return on paper. If you bought the index at any other time other than January 1st the year-to-date return has no significance to you. Most people comparing performance numbers just don't think about it in this way.
Let's use an easy example to show exactly what I mean. On January 2nd you invest $1,000 in a stock mutual fund. On July 1st we compare the performance of the mutual fund you purchased to the S&P 500 Index. The index is up 10% year-to-date and your stock mutual fund is up 11% year-to-date. This is very simple to compare because it's obvious your mutual fund beat the index return by 1%. What made this an easy comparison was the starting date.
Now let's use a different entry point for your mutual fund purchase. Let's assume you invested the $1,000 in the stock mutual fund on December 1st of the previous year. Now on July 1st when we review the year-to-date performance, the S&P 500 Index is still up the same exact 10%. Your stock mutual fund is still up the same 11% year-to-date. Your stock mutual fund did, in fact, outperform the index for the year-to-date period. Since you did not buy the stock mutual fund on January 1st makes this comparison irrelevant for two reasons: you don't have a common purchase date and you didn't sell on July 1st. What if the $1,000 that you invested on the previous December 1st was actually worth $970 on December 31st (assuming the stock mutual fund declined 3% during the month of December)?
Yes the year-to-date return on that July 1st is still up 10% on the index and on the stock mutual fund. The index went up 10% during those six months and so did your mutual fund. The value of the index (if you could have purchased it) would be $1,100 on July 1st and the value of your mutual fund would be $1,067. Do you still believe that the performance of the index for the year-to-date period has as much significance to your situation?... Continue reading