Performance - the only question that matters
The exercise I'm about to describe may hold a key insight into your investing skill and help you become a better investor in the future. Here are the three steps in this test.
Step One - Pull out your 12/31/07 investment statement
Go back to the days when the paradigm of real estate was that it could never go down, AIG, Lehman, and Bear Stearns were solid companies, and we believed our banking system was both sound and conservative. Look up your balance and write it down. Also, determine what proportion of your portfolio was in risky assets, such as stocks.
Step Two - Look at your portfolio as of 3/31/11
Look at the most recent quarter. You'll have it on line or soon be receiving it in the mail. Compare your current balance to the happy pre-crash days of 12/31/07.
Step Three- Adjust your ending amount for funds deposited or withdrawn
This is going to be the hardest part of this test. Say you've deposited $40,000 and withdrawn $10,000. You need to decrease the ending balance by net deposits, and increase it by net withdrawals. You then divide the gain or loss by the beginning balance on 12/31/07.
Say you had a $100,000 balance on 12/31/07, which was 50 percent in equities, and a $135,000 balance recently on 3/31/11. You deposited $40,000 but withdrew $10,000. Thus, you subtract $30,000 from your ending balance leaving you an adjusted ending balance of $105,000 or $5,000 more than when you started. Your gain was 5.0 percent (($105,000 - $100,000)/$100,000). Note that this is only an approximation of your return.
Now look up your grade.
Once you've estimated your return over these 13 tumultuous quarters, compare it to a simple index fund return using your same allocation of riskiness. Here is how an index portfolio performed, rebalanced at the end of each year. Note that only the 100% equity portfolio had a loss.
If you scored within one percentage point or better than the rebalanced index return, give yourself an "A" and a nice pat on the back. For others, here is my grading curve.
B - Within three percentage points
C - Within six percentage points
D - Within ten percentage points
F - Worse than ten percentage points
In the example I gave, the investor got a positive return of five percent on his portfolio that had 50 percent equities on 12/31/07. But this investor would have achieved an 11.83% return if he had a low cost portfolio and the courage to rebalance at the end of each year. This investor underperformed by 6.83 percentage points, giving him a "D" grade in my class.
If you think I'm a harsh grader, ask yourself how that "D" grade compares to losing out on $6,830 of cold hard cash the investor could have had by controlling expenses and emotions. I suspect this investor would take my "D" if they could get their cash back.
I'm happy to say I aced this investment test, which proved to be very difficult as markets were plunging. The answer may have been simple, though buying more stocks when they were down 55% was anything but easy. But investing is about focus and discipline. It's not about knowing today what the hottest performing stock of the last decade was, as CNBC seems to think is related to your investment skills.
My assessment of your performance
Here's what I think this test means to you.
Scored an A or a B - You are likely a skilled investor who understands the devastation emotions and expenses can have on your portfolio. Don't get cocky though, and think rebalancing will ever work as well as it has over the past few years.
Scored a C or lower - Give yourself a pat on the back for having the courage to take this test. Now ask yourself if you've learned from your mistakes. Don't just make the assumption that you would act differently the next time around.
Didn't take this test - There are probably several reasons you didn't take this test, but one might be that you don't want to know how you performed. If you can't muster the courage to handle the truth, you probably don't have any business being invested in the stock market.
More on MoneyWatch