Measuring Portfolio Performance: The Market-Conscious Side of the Rational Investor

Rational Measures of Portfolio Performance. The Time-Weighted and Money-Weighted rates of return are two standard rational measures of portfolio return.

This Part 1 of a Series.

It was sometime early this year when I finally decided to bring unto myself the task of measuring the rate of return achieved by my personal portfolio. The whole idea intrigued me—I knew it's making some money, but knowing how much money—well, that really captivated my imagination.

I know the exercise was somewhat hypocritical... I preach business perspective investing which always focus on the financial performance of the stock based on its merits as a true, performing business, and give little or no value to how its stock market price performed.

While I admit I measure my portfolio’s returns based on stock price performance, and that this is my yardstick as a market-conscious fund manager, I likewise admit and insist (and I don’t see any inconsistency in saying) that in my career as a rational investor, my focus, nonetheless has still been and always will be the virtues of the underlying business. Further, I see that using and practicing value investing principles in managing my portfolio is an experiment and a profitable endeavor altogether. It is an experiment which tests whether this premise is true: "that the market may take an inconveniently long time to adjust to a rational valuation; (we) don’t know what the mechanism is, but (we) can tell that in our experience, it usually does readjust eventually" – Benjamin Graham on the market being rational (taken from the book Warren Buffett: An Illustrated Biography of the World’s Most Successful Investor).

I hear too often executed stock trades already yielding double-digit returns in just days! But I always cringe at the thought that the bigger picture of how the overall portfolio performed (and not just in a year, but in years, even decades) will never be disclosed in an honest, structural, big-picture manner. Alas, we are proud too often of single, quick, profitable trades, but come an overall audit (which would also consider the sour, losing trades) to show the whole portfolio performance, we’re just a bit too lazy, even too proud, to submit ourselves to that test.

While market-conscious, the long-term rational investor nonetheless would differentiate himself from the excessively market-conscious, short-term trader in that he would still insist for a systematic, rational measure of rate of return where the consistency of his portfolio’s performance (not by the second, minute, day, week, or month, but by years, even decades) will be subjected to. It isn’t all about one-time, big-time, one-hit wonder gains or homeruns, anyway (we’re tired of this sort). We’re more interested in seeing and achieving consistent, double-digit returns that would stand the test of time. The business-sided logic in it is that it attempts to take advantage of the long-term effects of the power of compounding, banking on the idea that time is the friend of a good business, and if the market eventually does recognize business merits, then we should be comfortable to hold indefinitely and expect consistent market gains which should trace underlying business gains. Yes, it’s a career, and we don’t intend to do it amateurishly, but professionally. So we seek that professional, standard scorecard measure.

So what is this rational measure of rate of return? How exactly would one measure his overall portfolio performance? In summary, there are actually two rational approaches in measuring portfolio performance: the Time-Weighted (TW) rate of return and the Money-Weighted (MW) rate of return. TW attempts to capture how a fund yielded regardless of size, capital infusions, and withdrawals from the pool of fund—it is often referred to as the industry standard in the world of mutual funds. MW, on the other hand, captures the fund’s internal rate of return (IRR) and takes into consideration the size and timing of deposits and withdrawals. It simply pinpoints the absolute, real returns per actual fund results. Continue to Part 2: Time-Weighted Rate of Return: It's All About Relative, Simple Yields