The better benchmark for equities

Question: How do I know if my investments are doing OK in the stock market?—asked at “Ask a friend, ask Efren” free service available at www.personalfinance.ph, Facebook and SMS.

Answer:  Wise men say that it is not good to compare your achievements to the achievements of others. But for you to know that you are doing well in whatever it is you are doing, you will need to use benchmarks.

By definition, a benchmark is “a standard or point of reference against which things may be compared or assessed.” For example, how would you know if your pinky finger is short?  You will know as soon as you compare that finger to your other fingers.

In the same manner, you can compare the performance of your equity investing by measuring your returns over a specified period to those of other equity investments, provided that the parameters for investing between your investments and those of others are more or less the same.  By this reasoning, you cannot compare the performance of an actively traded fund to that of an index fund.

In addition, the way of computing returns must be the same.  For example, a cumulative return is but a simple or absolute way of computing returns and is not computed in the same way as compounded annual returns.

Cumulative returns do not take into consideration the time value of money. To demonstrate, which investment would have performed better, Investment A that generated a cumulative return of 100 percent or Investment B, which generated a cumulative return of 100 percent?  You would be hard put to judge which investment performed better until you know the period in which such performance was generated.  And with all other things being equal, the investment that generated the 100 percent over a shorter period would have performed better.

That is why between the two ways of computing mentioned earlier, annualized compounded returns are the better method for measurement covering periods in excess of one year.

Still, the better way of determining investment performance is by computing returns based on actual lengths of period weighted by the size of investments.  This method lends itself to portfolios where additions to portfolios are present (e.g. peso cost averaging).

Unfortunately, individuals tend to undercompute their returns because they do not factor in the benefits of reinvesting the cash dividends they earn on their stock investments. Investing in pooled funds does away with this problem because such funds compute their prices and performance with cash dividends reinvested.

But here lies another; the benchmark for portfolios that reinvest dividends cannot be the Philippine Stock Exchange Composite Index or PSEi because this index only computes price appreciation and not the reinvestment of dividends that the index component companies pay out.

Fortunately, the Philippine Stock Exchange (PSE) recently came out with the PSEi Total Return Index (TRI). Based on the disclosure of the PSE, “the PSEi TRI covers both price performance and income from dividend payments by reinvesting cash dividends according to their respective market capitalization weightings.”

So, if you want a more appropriate benchmark, that would be the PSEi TRI.  And if you want a simpler way of computing your returns, with professional management to boot, just invest in equity pooled funds.