Tune Your Portfolio With a Year-End Review, Part 1

So, how did you do in 1999?

Sure, you bragged about that 250% gain in Yahoo! ( YHOO) or that 1100% gain in Qualcomm ( QCOM) at the office holiday party. But overall, how did your portfolio perform? Even more importantly, what are you going to do for an encore in 2000? Does your portfolio still conform to your original strategy?

Each January at Heron Capital Management, we perform a review of each client's portfolio, comparing the risk characteristics of the portfolio to the client's risk profile, determining how far the portfolio's allocations have drifted from the original strategy and taking steps to bring the portfolio back into line.

We have a broad array of automated systems to help us do this. But with a Microsoft ( MSFT) Excel spreadsheet and data from all the free services on the Internet, you can perform the same analysis yourself on your own portfolio.

Here's a sample Excel spreadsheet, derived from the portfolio of one of our more aggressive clients, to give you an idea of what we do. ( Netscape users, right click on the link and save the file to your hard drive. You'll need Microsoft Excel software to view it.) With a little effort, this spreadsheet can be adapted to analyze your portfolio.

Now let's take it step by step:

  • Step 1: Evaluate performance against benchmarks.

    Even if you don't use portfolio-tracking software, you can reasonably estimate your annual return as follows: Get the total market value (including cash, mutual funds, stocks and bonds) of your portfolio from your year-end brokerage statement. Look up the same value from your year-end 1998 statement. Skim over your interim statements to see if you added or withdrew cash from your account during the year. The formula for calculating returns is:

    In the above chart, MV is the market value of the portfolio and CF stands for cash flow, or the sum of cash added or withdrawn during the year.

    If cash flows are no more than 15% of the total portfolio, this calculation will yield a reasonably close estimate. If cash flows are larger, calculate quarterly returns using the above method, then put together an annual return with the following formula:

    ((1+Q1return)* (1+Q2return)* (1+Q3return)* (1+Q4return)) - 1

    Let's try an example for a portfolio that was worth $100,000 on Jan. 1, 1999. Let's assume $10,000 in cash was added during the year, and at year-end, the portfolio was worth $150,000.

    (Note: You can enter your numbers for both formulas directly into the attached spreadsheet.)

    In 1999, the S&P 500 index returned 21%; the Dow Jones Industrial Average, 27%; the Nasdaq Composite, 84%; and the Russell 3000, 21%. Our example portfolio returned 69%, impressive compared to all but the Nasdaq. Last January, we decided to overweight technology and underweight financial services in our aggressive portfolios. Obviously, our client was rewarded, but as we will see below, the results are entirely attributable to being in the right sector.

    In benchmarking your portfolio, pick broader indices such as the S&P 500 or the Russell 3000. The Nasdaq is too much of a technology sector index at this point, and the Dow is too narrowly defined to be useful. If you have significant fixed-income exposure, calculate a blended benchmark (e.g., 60% S&P 500, 40% Lehman Brothers Aggregate Bond Index). Year-end returns are available from a variety of sources, including The Wall Street Journal and Barron's. Whether you beat or trail whatever benchmark you select, the important thing is to find out why.

  • Step 2: Examine the composition of your portfolio by sector.

    In a diversified portfolio (at least 25 stocks, no positions larger than 6%), about 80% of returns come from sector selection and 20% come from the individual stock selections. In 1999, the top-performing sector was technology; other sectors were mostly flat to lower. Assign each stock in your portfolio to one of these sectors:

    • Basic materials
    • Capital goods
    • Consumer, cyclical
    • Consumer, noncyclical
    • Energy
    • Financial
    • Health care
    • Industrial, cyclical
    • Services
    • Technology
    • Transportation
    • Utilities

    If you're not sure what sector a company belongs to, Market Guide provides this information on its Web site, as do Yahoo! and TSC.

    Sort your portfolio by sector and sum up the percentages in each sector. In our example, 67% of the portfolio is invested in technology; 18% in health care; 11% in a mix of services, energy, transportation and conglomerates; and 4% in cash. At our firm, a conservative portfolio would be invested about 25% each in tech, health care, financial services and other categories, so we weren't kidding when we said this portfolio is aggressive. We made a conscious decision to overweight tech and underweight financial services in 1999. In 2000, we intend to underweight tech -- at least in the first quarter -- and overweight financial services.

    Our clients generally benchmark our performance against the S&P 500. Sector composition of the S&P 500 is not readily available on the Web. However, the composition of the ( VFINX) Vanguard Index 500 fund perfectly matches that of index. So, by comparing the sample portfolio's sector allocation to that of Vanguard Index 500, we quickly see that, indeed, our outsize tech positions account entirely for our strong performance relative to the S&P 500. (Details are summarized in the spreadsheet.)

    In part 2 this afternoon, we'll talk about assessing your portfolio's risk.

    David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. At the time of publication, his firm was long all stocks mentioned in this article except Consolidated Edison, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback at DavidEdwards@HeronCapital.com.

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