DID YOUR PORTFOLIO PERFORMANCE MEET YOUR GOAL

If a portfolio rises by 5% in a year while the cost of living rises by 8%, has its owner gained or lost?

Fast Track (30 seconds)

• A result means nothing until it is set against a goal: the same return can be a triumph or a failure.
• Seven goals form a ladder, from “do not lose my money” to “earn the most for the least pain”. Each has its own test.
• Every test needs a yardstick: inflation, a safe government bond, or a tracker index that simply copies the market.
• Diversification is the simplest way to stop one mistake wrecking the plan.

Introduction

A portfolio can rise in value and its owner can still be poorer. That points to a neglected fact: a result means nothing until it is set against a goal.

This article sets out seven such goals, arranged as a ladder, and shows the yardsticks that make each one testable, from inflation to an index that copies the market.

Why It Matters

What is happening: most private investors judge themselves by a single question, whether the number went up.

Why it happens: the number is easy to see, while the goal behind it is not.

Why it matters: a rising number can hide falling purchasing power, and a risky strategy that happened to work can be mistaken for skill.

What might happen next: speculatively, as inflation and government borrowing stay in the news, more investors will ask what their portfolio is for.

Contents Cover the Following

1. Start With the Goal, Not the Return

2. The Goal Ladder: Seven Rungs

3. Racing the Market: The Tracker Index Test

4. Spread the Risk: Diversification

5. A Scorecard, Not Just a Number

6. Glossary

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1. Start With the Goal, Not the Return

Two friends each turn £100 into £105 in a year. The first wanted only to keep their money safe, and is delighted. The second wanted to beat a savings deal paying 6%, and is disappointed. The result is identical, the verdict is opposite, and the difference is the goal.

Before an investor can say whether they did well, they must decide what doing well means. A good tracking tool should report not only whether money was made, but whether the chosen goal was reached, including the feelings behind it: how much loss and uncertainty the investor can live with.

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2. The Goal Ladder: Seven Rungs

2.1 The ladder at a glance

Each rung is a different attitude to money, with its own way of checking success. Most investors need not reach the top. The right rung is the one that matches the investor.

Rung	Goal	Checked with	The thought behind it
1	Preserve capital	Portfolio value against money put in	“I don’t want to lose what I have.”
2	Preserve purchasing power	Real return: return minus inflation	“I don’t need to get rich; I don’t want to become poorer.”
3	Beat the risk-free gilt return	Portfolio return minus gilt return	“If I take the risk and do the work, I want to be paid for it.”
4	Maximise absolute return	Total return over a set period	“I will accept substantial risk for substantially greater wealth.”
5	Maximise risk-adjusted return	Sharpe ratio	“I want to win without taking unnecessary risks.”
6	Maximise downside-adjusted return	Sortino ratio	“I can tolerate fluctuations, but not serious losses.”
7	Control the maximum loss	Maximum drawdown and position sizing	“I know how much pain I can take.”

2.2 Rungs 1 and 2: keep it, then keep its buying power

The first rung is simple and feels safe: do not lose the money started with. Its weakness is inflation. Suppose a chocolate bar costs £1, so £100 buys 100 bars. If prices rise by 4%, the bar costs £1.04 and the same £100 buys about 96. The number on the statement has not changed. What it buys has.

The second rung exists to catch this. It asks for a real return, what was earned minus inflation. An investor who earns 7% while inflation runs at 4% has gained about 3% in real terms. The yardstick can be inflation itself, or an index-linked gilt, a government bond whose payments rise with inflation.

One more yardstick deserves a brief mention. Some investors, known as gold bugs, believe that pounds and dollars are only credit, promises that lose value because governments and banks can create more of them, while gold is real money, dug up only slowly. They argue that a unit of measurement should stay the same size, and that a pound shrinks over time like a rubber ruler, so they prefer to measure performance in gold. Most investors still use pounds, and gold has its own ups and downs, but the argument is worth knowing.

2.3 Rung 3: be paid for the work

Why take risks if a decent return is available almost for free? In the UK a gilt is a loan to the government, and it is the usual “safe” comparison. Anyone offered £5 pocket money for doing nothing would want a paper round to pay clearly more than £5. An investor who takes risks and does the research should likewise expect to beat the gilt. It is the key hurdle for a private investor, someone investing their own money rather than a professional’s.

2.4 Rungs 4 to 7: the score, the efficiency and the pain

The fourth rung is the “highest score” goal, and its danger is obvious. A racing driver flat out may win one race but is far more likely to crash, and a large return earned by a huge risk may not be repeatable.

The fifth and sixth rungs ask how efficiently the return was earned. Two friends both finish the year £10 up, one after a smooth ride and one after a roller coaster. The Sharpe ratio rewards the smooth ride, measuring extra return per unit of bumpiness. The Sortino ratio counts only the downward bumps, since losing £10 hurts more than finding £10 pleases.

Nobody shows an investor the biggest drop in advance, so the limit must be set before the market tests it.

The seventh rung does exactly that. The biggest fall from a high point is the maximum drawdown: a portfolio that climbs from £100 to £120 and then falls to £90 has suffered a drawdown of 25%, since £30 is a quarter of £120. Position sizing, limiting how much goes into any one investment, stops a single mistake breaching the limit.

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3. Racing the Market: The Tracker Index Test

3.1 What a tracker index is

Every day the news reports an index, such as the FTSE 100. An index is a scoreboard for part of the market: a list of investments, in this case the 100 biggest companies listed in London, whose combined ups and downs give one number.

A tracker fund simply copies an index, buying the same investments in similar amounts, so it earns roughly what the index earns, less a small fee. Many trackers are ETFs, funds that are bought and sold like shares. Think of a pupil who copies the class average: never top of the class, never bottom, and very cheap.

3.2 The tracker test

The test is one subtraction: the portfolio’s return minus the tracker’s return over the same period. If the answer is above zero, the investor’s choices added something. If it is below zero, the same money in a tracker would have done better, with far less work.

This is a second version of the paper-round hurdle from Rung 3. The gilt is the reward for doing nothing and taking almost no risk. The tracker is the reward for doing nothing and taking the market’s risk. An investor who does the research should ask both questions: did I beat the safe option, and did I beat the easy option? The extra return that comes from the investor’s own choices is called alpha, and how strongly a portfolio moves with the market is called beta.

3.3 Picking a fair tracker

A fair test compares like with like. A portfolio of shares belongs against a shares tracker, not a bond tracker, and a portfolio that mixes shares and bonds needs a matching mix. Both returns should include dividends, be counted after fees, and cover the same dates. One year proves little, because luck can flatter or punish anyone, so the test is worth repeating over several years.

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4. Spread the Risk: Diversification

Consider two seaside stalls. An ice-cream stall earns £100 on a sunny day and £20 when it rains. An umbrella stall earns £20 in the sun and £100 in the rain. Owning one stall means feast or famine. Owning both earns £120, whatever the weather. That is diversification: mixing things that do well in different conditions.

Investors call the degree to which two things move together their correlation. At +1 they move in step, at 0 they are unrelated, and at -1 they move in opposite directions. Real markets are never so tidy, and in a panic many things fall at once, so the protection is never complete. Twenty shares in one industry are not diversified either, because they tend to fall together.

Diversification can be put into practice in four steps.

1. Sort every holding into groups: the kind of asset (shares, gilts, cash, gold, property), the country or currency it is tied to, and the industry it belongs to.
2. Set limits for any one holding and any one group. For example, no holding above 15% and no group above 40%. These figures are illustrations, not recommendations.
3. Test the mix against the last rough patch in the markets. If everything fell together, the portfolio is less diversified than it looked.
4. Rebalance once or twice a year, trimming what has grown too large and topping up what has shrunk.

There is such a thing as too much: dozens of small holdings add cost and complexity, and dilute the best ideas. The aim is to spread sensibly, not as thinly as possible.

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5. A Scorecard, Not Just a Number

The most useful spreadsheet does not ask whether money was made. It asks whether the chosen goal was reached. The investor selects a rung and enters the portfolio value each month, and the sheet reports Met or Not met against the right test for that rung, whether it is money put in, inflation, the gilt, a target return, a Sharpe or Sortino ratio, or a loss limit.

It also sets the portfolio beside inflation, the gilt and a market index, so the tracker test from Section 3 needs only one extra column: the tracker’s monthly return. No ratio can measure personal stress, so the loss limit is the investor’s own judgement of what can be lived with.

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Bottom Line

A result means nothing until it is set against a goal, and a goal means nothing until it is measured against a fair yardstick.

The gilt yield shows what can be earned relatively safely. Inflation shows what is happening to purchasing power. A tracker index shows what the market itself delivered. Alpha and beta show how much of a return came from the investor’s choices and how much from the market. Sharpe and Sortino measure how efficiently risk was used. Position sizing and diversification control it. And personal risk tolerance decides whether the result can be lived with.

Choose the rung, then choose the yardstick.

6. Glossary

Every term used in this article, and a few more, in plain English. Terms are grouped by theme.

6.1 Money and credit

Gold: A metal that has served as money for thousands of years. On this blog it is treated as money in the strict sense: a physical asset, owned outright, that is nobody else’s promise and cannot be created by decree. It pays no interest, and its price, measured in fiat currency, can rise and fall like any other.

Store of value: Something that keeps its buying power over time, so that what is saved today can still buy similar things in the future. Money is traditionally said to do three jobs: it is a way to pay, a way to measure prices, and a store of value. Gold’s supporters say it does the third job best. Example: a popular story says that an ounce of gold bought a good toga, the draped woollen robe of a Roman citizen, in ancient Rome, and buys a good tailored suit today. If true, gold has kept its buying power for about two thousand years, while the currency of ancient Rome no longer exists. Treat it as a rule of thumb, not exact history: nobody can prove the Roman half, and the price of gold measured against suits has wobbled a good deal over the years.

Fiat (credit): Currency such as the pound, dollar, euro or baht, which has value because a government declares it legal tender and people trust it, not because a physical asset stands behind it. The word is Latin for “let it be done”. On this blog fiat is treated as credit: a promise issued by a government or bank, which central banks can create and commercial banks create whenever they lend.

Debasement trade: An investment approach based on the view that governments tend to create ever more fiat currency, so that each unit buys less over time. Followers therefore favour assets that cannot be created at will, such as gold, over cash and bonds denominated in the currency. The word comes from the old practice of rulers mixing cheaper metals into coins, and, like any investment idea, the trade can be early, wrong, or both.

6.2 Wealth and assets

Wealth: Everything a person owns that has value, minus everything they owe. It is different from income, which is the money that comes in each month or year. Wealth is the pile, and income is the stream that tops it up. Example: savings of £5,000 plus a bike worth £200, minus £100 owed to a friend, gives wealth of £5,100.

Financial asset: An investment that is a claim on something, such as a share in a company, a government bond, or money in a bank. It exists as a record rather than a thing that can be held, and its value depends on someone else, the company, the government or the bank, keeping their side of the deal. Example: a share in a company, or a fund that says it holds gold for you, which is a claim on gold rather than gold in your hand.

Physical asset: A real thing with value in itself, which can be touched, such as a house, a piece of land, a painting or a gold bar. It is owned outright and its value does not depend on anyone else’s promise, although its price can still go up and down. Example: a gold coin in your hand.

Portfolio: All the investments a person owns, added together. Think of it as a backpack of things bought in the hope that they will grow in value.

6.3 Growth and prices

Inflation: The general rise in prices. When inflation is high, each pound buys less than before. Example: if a £1 chocolate bar costs £1.04 a year later, £100 buys about 96 bars instead of 100.

Return: How much investments grew, or shrank, over a period of time, usually shown as a percentage. Example: £100 becomes £105, so the return is 5%.

Nominal: The number written on a statement, before allowing for rising prices. Example: £100,000 is £100,000 in nominal terms, even if it buys less than it used to.

Real return: Investment return after taking away inflation. It shows how much better off an investor truly is. Example: earning 7% when inflation is 4% gives a real return of about 3%.

6.4 Goals and yardsticks

Capital preservation: Protecting the nominal amount of money invested. It does not necessarily protect what the money can buy, because inflation can reduce that. Example: keeping £100,000 close to £100,000.

Purchasing-power preservation: Keeping the ability of money to buy roughly the same amount of goods and services over time. It is the goal tested by the second rung of the ladder, using real return.

Benchmark: A yardstick against which a portfolio is measured, a bit like comparing a test score with the class average. A conventional gilt can be the benchmark for ordinary (nominal) returns, an index-linked gilt the benchmark for real returns, and a tracker fund the benchmark for a portfolio of shares.

Excess return: The return earned above a chosen benchmark. Example: a portfolio earns 8% and the gilt pays 4.5%, so the excess return is 3.5%.

6.5 Government bond words

Conventional gilt yield: A gilt is a loan to the UK government, and the yield is its yearly return shown as a percentage. It is a useful “risk-free” yardstick because it shows what could be earned without taking much investment risk. It remains a promise paid in pounds.

Index-linked gilt yield: The real yield on a UK government bond whose payments rise with RPI inflation (RPI is one way of measuring inflation). It shows the return available above inflation, not just the plain return.

Risk-free gilt return: The return from a UK gilt, commonly used as the starting line against which riskier investments are judged. “Risk-free” is a shortcut: it means there is very little chance of the government failing to pay, not that nothing can go wrong, because prices can still move and inflation can still bite.

6.6 Markets and trackers

Index: A list of investments that works like a scoreboard for a part of the market. Its combined ups and downs give a single number showing how that part of the market is doing. Example: the FTSE 100 follows the 100 biggest companies listed on the London Stock Exchange.

Tracker fund: A fund that copies an index instead of trying to beat it. It buys the same investments in similar amounts, so it earns roughly what the index earns, less a small fee. Example: like a pupil who copies the class average, never top of the class, never bottom, and very cheap. Its return is a popular yardstick for judging an investor’s own choices.

ETF: Short for exchange-traded fund: a fund that holds a basket of investments and is bought and sold on a stock exchange, like a share, at prices that change through the day. Many ETFs are trackers that copy an index, while others follow gold, bonds or other things. Example: an ETF that tracks the FTSE 100 lets an investor own a small slice of all 100 companies in one purchase.

6.7 Risk words

Risk: The chance of losing money, or of not reaching an investing goal.

Volatility: How much the price or return of an investment bounces up and down. Big bounces are not automatically dangerous. What matters is whether they stop the investor reaching the goal.

Downside risk: The chance that an investment falls below a target or minimum return chosen in advance.

Drawdown: A fall from a high point to a low point, before the value recovers. The biggest one is called the maximum drawdown. Example: a portfolio goes from £100 up to £120, then down to £90. The drawdown is £30, which is 25% of £120.

6.8 Living with risk

Personal risk tolerance: How much financial loss and uncertainty an investor can realistically accept without giving up the plan.

Personal stress: How worried or upset an investor feels when investments drop. It differs from person to person, and no ratio, not even Sharpe or Sortino, can measure it.

Position sizing: Deciding how much money to put into each investment. Smaller positions limit the damage that any single investment can do to the whole portfolio. Example: not putting all the eggs in one basket.

Rebalancing: Bringing a portfolio back to its plan. Over time winners grow larger than intended, so the investor trims them and tops up those that have shrunk, or adds new money to the smaller holdings. Example: the plan says 50% shares, but a good year takes them to 60%, so some shares are sold, or new money goes elsewhere, to get back to 50%.

6.9 Moving together

Correlation: How much two investments move together. A value of +1 means they always move the same way, 0 means they are unrelated, and -1 means they move in opposite directions. Investments with low or negative correlation make good partners, like the ice-cream stall and the umbrella stall.

Diversification: Spreading money across investments that do not all rise and fall together, so that one problem cannot sink the whole portfolio. Example: owning shares, gilts, cash and gold, in several countries, instead of one company’s shares.

Beta: How strongly a portfolio tends to move when the wider market moves. A beta of 1 means roughly the same movement as the market, above 1 means it swings more, and below 1 means it swings less. Example: with a beta of 1.5, if the market rises 10%, the portfolio tends to rise about 15%.

6.10 Scorekeeping

Alpha: The part of a return that cannot be explained by simply being in the market. It is often seen as the value added by the investor’s own decisions, and a rough everyday check is to compare the portfolio with a tracker fund. Example: if a whole class does well because a test was easy, alpha is how much better one pupil did on top of that.

Sharpe ratio: The extra return earned for each unit of total volatility. It counts both upward and downward bounces as bumpiness, so a higher figure means the return was earned more efficiently.

Sortino ratio: The extra return earned for each unit of downside volatility. It counts only the bounces that hurt, the downward ones, which suits an investor who minds losses far more than ordinary swings.

Unitising the portfolio: Dividing a portfolio into equal parts called units, the way a fund does, and giving each unit a price. The unit price is the value of the portfolio divided by the number of units. Money paid in buys new units at today’s price, and money taken out sells units at today’s price, so deposits and withdrawals of course make the value of the portfolio go up and down, but cannot ever change the unit price. Only investment performance changes the unit price. This is the only true way to measure returns, and to for example compare them with a tracker fund, whose price works in the same way. 

For example: a portfolio of £100,000 is 100,000 units at £1.00 each. A year later it is worth £110,000, so the unit price is £1.10, a gain of 10%. Adding £11,000 buys 10,000 new units at £1.10, giving 110,000 units worth £121,000. If the value then rises to £133,100, the unit price is £1.21, so the true gain is 21%, not the 33% that comparing £133,100 with £100,000 would wrongly suggest.

6.11 Protection tools

Stop-loss: A rule set in advance: if an investment falls to a certain price or loss level, it is sold to stop further losses. It can control downside risk, but it can also force a sale during a fall that would have been temporary.

Hedge: A second position that is expected to gain when the main investment loses. It works like insurance: it usually costs something, and the hope is never to need it. Example: buying a currency-hedged fund so that a falling dollar does not hurt US shares.

Put option: A contract that gives the right, but not the duty, to sell something at a fixed price before a set date, in return for a fee called a premium. It can expire worthless. Example: paying for the right to sell shares at £100 even if the market price drops to £70.