As the fall semester draws to a close at Seton Hall University (where I teach), it's time for me to submit grades for my students' performance. This is never an easy process. However, what I have found in academia and in my role as a registered investment advisor at LakeView Asset Management is that it is necessary to devise an objective measure of performance.

Many installments of

The Finance Professor mention the concepts of investment performance measurement and investor accountability. Now I will elaborate on those notions by discussing an essential guide to investment-performance measurement. Here is what is necessary:

Define a Time Horizon

Investors will typically judge their performance on an annual basis. However, you may decide to divide an annual period into

quarters and maybe even months.

Whether or not your long-term investment horizon is more than a years away (for example, you may be financing retirement or college), you should still measure your performance annually.

Should you want more time granularity in the future, I suggest you start out with shorter time periods to avoid having to go back later.

Keep Detailed Records

Performance calculations are not as easy as taking the difference between an opening balance and a closing balance, dividing by the opening balance, subtracting one (1) and displaying it in percentage terms. The reason is that a series of

cash flows may take place between the beginning and the end of the investment period.

Let me illustrate with a simple scenario. Say you start out with $100,000 on Jan 1 and end with $1,000,000 on Dec 31. During the year, you added $850,000 to the account. Did you make $50,000 on a $100,000 investment or did you make $50,000 on a $950,000 investment?

The answer is both and neither.

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)

,

Lehman Brothers Aggregate Bond Index

(AGG) - Get Report

and the

MSCI

( MXB).

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) versus that of a mega-cap like

Johnson & Johnson

(JNJ) - Get Report

.

Once you accurately classify your asset class and investment target, then you can seek out a benchmark that best estimates the risk profile of that asset class which you will be investing in. To accomplish this, you will have to do some research. There are many sources that can help you in this process. Amongst them are:

  • Yahoo! Finance devotes several sections to stock indices http://finance.yahoo.com/indices and composite bond rates .
  • Morgan Stanley Capital International, commonly known as MSCI Barra produces its own proprietary indices. While the details and analytics of MSCI Barra are only available by subscription, the indices and some related data are available for at no cost on the company's Web site.
  • The American Stock Exchange has excellent resources on its Web site that may help to equate your particular asset to an ETF, which you can use as a benchmark index. (To learn more about ETFs, visit the TheStreet.com ETF Center.)

While I cannot tell you which benchmark is best for you, I urge you to be consistent and use the same benchmark over time.

After you've selected a benchmark, the hard work is done and it's time to compare your performance against your benchmark. If you have outperformed the benchmark, then your

active investment management has done better than the

passive returns that you could have earned by just

investing in the index itself. Conversely, underperformance would signal that your investment management skills are "sub-par."

From A to F: How I Grade Investment Performance

My Seton Hall students know me as a grader with high standards. And as a professional investment advisor, I don't turn the machines off until I know how I performed -- for the day, the month and the year.

The following is my grading system for investment performance. Please note: Performance should be calculated after subtracting all fees and expenses.

A:Your rate of return substantially outperformed your benchmark, by more than 5.00%. B: Return performance beat your benchmark by at least 0.25%, but less than 5.00%. C: Performance met your benchmark (or within a reasonable margin thereof, say, +/-0.25%). D: Performance was below your benchmark by at least 0.25% but less than 5.00%. F: Performance was substantially below your benchmark, by more than 5.00%

To those letter grades you can add a plus (+) if you were profitable or a minus (-) if you lost money. The grading system is relative, but it also takes a little absolute performance into account.

For example, let's look at 2006. If you were up 18% or more that year and your benchmark was the S&P 500, which returned 13.62%, then you would get an A+, because your performance substantially outperformed your benchmark while making money. However, let's say you earned 8% in a year when your benchmark was up 10%, then that would earn you a D+ because your performance was below your benchmark while still generating a positive absolute return. I

said

I was a tough grader.

Also, you can outperform your benchmark and still lose money. For example, imagine that you investment return dropped 3%, but your target benchmark was off 5%. According to this grading system, that performance would get a B-. In other words, you did well in a tough year.

Homework Time

Your homework between now and the close of this year is to have a systematic process in place to measure your performance, identify a benchmark and then start to grade how your investments have done.

At the time of publication, Rothbort was long MXB, although positions can change at any time. Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities. Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University. For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.