Friday, July 8, 2011

Are You There Yet?

For U.S. investors, 2010 came in well above the long-term historical averages, with the broad-based Wilshire 5000 Composite Index up 17.7% on a total return (dividends and appreciation) basis. As usual, some categories did better than others, with diversified international stocks returning 7.8% and intermediate domestic bonds delivering 6.5%.

But how did your portfolio do? And more importantly, what progress did you make toward your long-term financial goals? While investment performance is important, long-term financial success depends on a lot more than what "the market" does from year to year. Below, I will walk through four key steps to help you get a handle on just how you're doing vis-à-vis the market and your financial goals.

Step 1: Benchmark your portfolio's performance
To get an idea of how your portfolio performed relative to the market, compare the benchmark return to your portfolio's actual return (if you use an investment advisor, hopefully this is all done for you). Chances are some areas of your portfolio did better than others, which is fine. It's not likely every area will do well at the same time—that's why it's critical to be well diversified across (and within) asset classes.  For instance, if in 2010 your domestic large-cap stocks did worse than your small-cap holdings, that doesn't mean you should give up on domestic large-cap. The important thing is that each part of your portfolio did well relative to its appropriate market benchmark. If that is not the case, step two will help address the performance problem.

This is also a good time to rebalance your asset allocation back to your long-term target if you didn't get around to it at year end. With the tax-law changes we've seen over the past few years, you may be able to give yourself an additional edge by being tax-smart about how you implement your asset allocation between taxable vs. tax-advantaged accounts.

Step 2: Measure the performance of individual investments
Of course, you'll want to see how each of your stocks, bonds and mutual funds performed in 2010 relative to their appropriate peer group and index.  But no matter what led you to purchase a particular stock, bond or mutual fund in the first place, you need to answer one key question: If you didn't already own it, would you purchase it today?

Step 3: Assess your personal net worth
Now let's take a look at the bigger—and more important—picture by updating your personal net worth statement. This is similar to what a business does with its balance sheet at the end of the year. Start calculating your personal net worth by totaling up all your assets (what you own, including your taxable and tax-advantaged investment accounts, your home, other property, equity in your business, etc.) and all your liabilities (what you owe).  If you did all this for 2009, you can compare how your finances performed since last year. Did your bottom-line net worth increase in 2010?  With financial statements in hand, you can see what portion came from the return on your portfolio vs. other factors, such as changes in the value of your home or other real estate, paying off debt, and so on.

Step 4: Make or update your plan
Measuring progress toward your goals is difficult, if not impossible, when you don't have a plan. Putting one in place involves assessing your current situation, identifying your goals—retirement, college, and so on—then formulating a savings and investment plan to help you reach them, as well as a distribution plan to fulfill your goals. Of course, no matter how good your plan is, it won't be of much help unless you take action.  A sound plan, properly implemented and monitored along the way, can help you achieve the ultimate goal—peace of mind—as you find the right balance between working toward your future goals, including a secure retirement, and enjoying the here and now.

Remember, measuring progress toward your goals involves much more than simply focusing on the performance of your investments.  It's a comprehensive look at your spending and saving habits, debt management, tax and estate planning, gifting and more—all within the context of the economic, financial and market environment. Remember, too, planning is not a one-time event, but an ongoing, lifelong discipline. 

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