How to Measure Your Investment Performance

What matters is when that $850,000 was added. If it was added on Feb. 1, then the additional funds would have a greater weighting on the investment return than if the funds were added on Dec. 15. What we need to do is calculate the internal rate of return (IRR) for the portfolio during the period under review.

The IRR is the single most effective rate of return to be applied to all capital flows (investment and withdrawals) during the period under review. This can be best accomplished by maintaining a spreadsheet or database of the cash flows and the market values of the account for the relevant days in the reporting period.

Here is an example of calculating the IRR for a theoretical account:

Set a Benchmark

I like to look at investing as a game of golf. Performance for a golfer is measured against the "par" rating for the particular course, which is the amount of strokes that a golfer is expected to complete an individual hole or a round of 18 holes. In the investment world, a benchmark can be considered par.

Here is what you need to know to help you determine the benchmark or par for your investments:

Benchmarks come in two varieties: absolute and relative. Absolute benchmarks are fixed annual returns against which performance is measured. This could be 1%, 5% or really any rate that you desire. The problem with this type of benchmark is that it lacks the flexibility to adapt to dynamic marketplaces. Thus, absolute returns are not that prevalent in the investment world. The best example of an appropriate use of absolute return measurement is for dedicated short sellers who have no natural index to compare their returns to.

This brings us to relative performance measurement, which requires comparison of investment performance to a publicly quoted index or benchmark (see "Define Your Stock Index" ). Examples of benchmark indices would be the S&P 500 (SPX Quote), Lehman Brothers Aggregate Bond Index (AGG Quote) and the MSCI (MXB Quote).

Now how do you select an index or benchmark? The best way is to start by looking at your asset classes and your individual risk /return profile (see risk tolerance ).

Risk and return boil down to tradeoffs. The more risk you take, the greater the potential for you to reap larger returns. However, there is a price for that potential for greater returns. That price comes in the form of the possibility of larger losses. For example, a small-cap stock (asset class: equity ) could yield larger gains than a large-cap or mega-cap stock, but your loss potential might also be greater with that small-cap stock.

The reason for this is simple: the smaller cap stock has less certain earnings and higher volatility than a larger cap stock. For example, compare the returns and volatility for small-cap pharmaceutical company like Penwest (PPCO Quote) versus that of a mega-cap like Johnson & Johnson (JNJ Quote).