We show you how to measure your performance.
There's only one reason to invest in individual stocks: to earn a better return than you'd get by investing in the whole market. If you can't choose stocks that consistently outperform a passive index tracker, your stockpicking approach will not only be a waste of time, but will also seriously damage your wealth.
The only way to know if you're any good as a stockpicker is to measure your performance.
Most investors don't make a one-off, lump-sum investment. We tend to add money to our portfolios over time, whether regularly or irregularly; and, occasionally, we may withdraw money, for example, to pay a child's school fees or fund a holiday.
To get over the difficulty of measuring the performance of a portfolio that has money going in and coming out, we can adopt the principle of 'unitisation', which is used by unit trusts/OEICs.
Concrete examples are generally easier to grasp than abstract theory, so I'm going to use the Family Firms Portfolio to show you how unitisation works in practice.
The Family Firms Portfolio is being constructed over a period of time, using The Motley Fool ShareBuilder service. We are making regular investments of £150 a month.
First investment -- 7 July
The first time you put money into your portfolio, you decide on an arbitrary unit value. You then convert your initial cash injection into units.
In the case of the Family Firms Portfolio, let's say we decide our unit value is £1. As our initial investment is £150, the portfolio consists of 150 units (£150/£1).
Second investment -- 5 August
Each time we inject new money into the portfolio, we look at its value just before doing so.
Ahead of our second family firms investment the portfolio value was £178. We divide the value by the number of units to get the current unit value: in this case, £178 divided by 150 units, giving a unit value of £1.19. We then divide the new cash being injected (£150) by the unit value (£1.19) to give the number of new units being created: 126.
So our portfolio now consists of 276 units (150 + 126).
Third investment -- 7 September
We repeat the process with each new injection of cash.
Ahead of our third investment the value of the portfolio was £348. Dividing £348 by the number of units (276) gives a unit value of £1.26. Again we divide our new cash injection of £150 by the unit value -- this month £1.26 -- giving us 119 new units.
The portfolio now consists of 395 units (276 + 119).
Current value -- 17 September
We can see how the Family Firms Portfolio has performed in its short life to date.
The current value of the portfolio is £502, which, divided by the number of units (395), gives a unit value of £1.27. So, the unit value has increased 27% (£1.00 to £1.27) since we made our first investment on 7 July.
If money is permanently removed from the portfolio, we follow the same procedure, but subtract the units. So, if on 17 September we decided to take £254 out of the portfolio, we would divide that amount by the unit value of £1.27, which would tell us that £254 is the equivalent of 200 units. As we are 'subtracting' the cash from the portfolio, we subtract the units.
The portfolio now consists of 195 units (395-200) and is valued at £248 (£502-£254); and the unit value remains the same -- as it should -- at £1.27 (£248/195 units).
Going back and unitising an existing portfolio can be a lot of work if it was started a long time ago. But you can unitise it from today, simply by looking at the current total monetary value, assigning an arbitrary unit value, and calculating a base number of units for going forward.
It doesn't take much time to manually update a unitised portfolio -- and even less time if it's set up in a spreadsheet. Remember, the number of units only changes when new money is added or money is permanently withdrawn.
All trades within the portfolio, including the reinvestment of dividends and temporary holdings of cash, have no impact whatsoever on the number of units.
Once your portfolio is unitised, you are in a position to make a like-for-like comparison of your performance with a suitable index, index tracker or actively managed fund.
In the case of the Family Firms Portfolio, our 'investment universe' is UK-listed stocks. If we weren't stockpicking the money would probably be going into a FTSE All-Share tracker, so it's appropriate to use such a tracker as our benchmark.
Also, because we are planning to reinvest dividends, it makes sense to benchmark against the 'accumulation' version of the tracker; if we were routinely taking dividends out, the 'income' version would be the choice.
We can pit our portfolio against the HSBC FTSE All-Share Index fund, for example, which is just one of a number of suitable All-Share trackers:
| ||Unit value|
at 7 Jul
at 17 Sep
I hasten to add that this is merely an illustration of what unitisation allows you to do. A couple of months is way too short a period to draw any conclusions about a portfolio's performance.
However, if after 5 or 10 years you find you've been handsomely outperforming your benchmark, you may just be cut out for stockpicking.
Equally, if you've miserably underperformed over such a period, it may be time to start thinking about passive investment.
You won't know either way, though, unless you measure your performance. Get unitising!
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