Measuring portfolio performance is often difficult. For example, suppose that you invest $2,000 in a mutual fund that returns 15 percent in the first quarter of the year. In each of the next three quarters, you invest $2,000, but the fund doesn’t provide any returns during those months. Your return on the first $2,000 is 15 percent. Your return on $6,000 for following nine months is zero. The fund reports an annual gain of 15 percent, not counting dividends and gains distributions. However, these percentages don’t mean that you should measure performance on a short-term basis. Market prices vary and returns fluctuate for many reasons. What really counts is the true rate of return, which can’t be measured from quarter to quarter.

Another problem in measuring portfolio performance is risk. Risk is defined as the variability of returns. In other words, the more the returns vary, the greater the risk. One of the disadvantages of using standard deviation (a measurement of the variability of historical returns around the average return) is that it considers good variability. Good variability means that returns are exceeding expectations — an event that increases the stock’s volatility and standard deviation. The stock is now considered more risky because returns are higher than expected. What this shows is that standard deviation isn’t always a good way to judge risk. In other words, standard deviation is just a measurement of volatility. Risk enters the picture only if volatility is below the investor’s return target.

You have many ways to measure the performance of your portfolio. One way to measure performance is to use benchmarks — that is, compare the performance of your various investments with top performances and indices. For example, you can rank them by

• P/E ratio: Divide your stocks into capitalization groups (small-cap, midcap, and large-cap) and rank each group by P/E ratio. Compare your investments with top-performing stocks in each capitalization group daily and weekly. (For more information about capitalization groups, see Chapter 7.)
• Yield: Divide your fixed-income investments (bonds and Treasury securities) by quality rating and then rank each group by yield. Compare your investments with the top-performing bonds in each asset allocation class.