Measure Progress Toward Your Long-Term Goals

April 30, 2013

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

For US stock investors, the year 2012 came in above the long-term historical averages, with the broad-based S&P 500® Index up 16% on a total return (dividends and appreciation) basis. As usual, some categories did better than others, with diversified international stocks returning 17.3% and intermediate domestic bonds delivering 4.2% (MSCI EAFE® Index Net of Taxes and Barclays US Aggregate Bond Index, respectively).

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, we'll 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

First, assess the performance of your portfolio as a whole, including all your taxable and tax-deferred accounts. Compare your portfolio's actual performance in 2012 (allowing for any deposits or withdrawals during the year) to a benchmark return of appropriate market indexes weighted to match your target asset allocation.

For example, say you're a moderately conservative investor and your target asset allocation is 25% large-cap stocks, 5% small-cap stocks, 10% international stocks, 50% bonds and 10% cash investments. To calculate your benchmark return, follow the process illustrated in the table below. Look up the 2012 return for each asset class's benchmark index, and multiply it by your percentage weight for that asset class to get a weighted return. Then add up the results for your benchmark portfolio return.

Note: Performance is typically measured as a time-weighted rate of return for reporting purposes, which ignores cash inflows and outflows (it assumes investment income and distributions are reinvested). If you added new money or took withdrawals from your portfolio during the course of the year, you could also measure your performance using an internal rate of return calculation which takes cash inflows and outflows into account on a money-weighted basis. (Schwab clients can check with their representatives for more information.)

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, they should be able to do this 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 2012 your domestic large-cap stocks did worse than your international holdings, that doesn't mean you should give up on domestic large-cap. The important question is how your portfolio performed relative to its appropriate benchmarks. If it underperformed, step two will help to address the problem.

Here's an example of a custom benchmark that was created for a hypothetical portfolio with a moderately conservative target allocation. The custom benchmark will change, of course, depending on what benchmarks you use for different asset classes and how you weight them.

Source: Schwab Center for Financial Research. Past performance is no guarantee of future results. Returns include reinvestment of dividends and interest. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

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.

For example, investments that generate long-term capital gains and stocks paying qualified dividends are generally good candidates for taxable accounts, since they are generally taxed at a lower rate compared with ordinary income. Investments that tend to lose more of their current return to taxes—taxable bonds, real estate investment trusts (REITs), stocks and stock funds that generate lots of short-term capital gains which are taxed at the higher ordinary income rate—could be placed in tax-advantaged accounts such as your 401(k) and traditional IRA.

Step 2: Measure the performance of individual investments

Once you see the big picture, you'll want to see how each of your stocks, bonds and mutual funds performed in 2012 relative to their appropriate peer group and index. Start by logging into your account on schwab.com.

• For mutual funds: Click on the ticker, which will take you to our Mutual Fund Report Card. Then click on the Performance tab, and you'll see a comparison of your fund's performance to its fund category average and an appropriate index. If a mutual fund is seriously underperforming its category average, clients can consider using the Schwab Mutual Fund OneSource Select List® to find alternatives.
• For stocks: Click on the ticker, which will also take you to a Schwab research report. Click on the Peers tab, and you'll find a comparison of that stock's performance to an appropriate index, as well as its Schwab Equity Rating®. Stocks rated A or B are projected, on average, by Schwab to outperform the equity market in the year ahead. Stocks rated D or F are expected to underperform.

Step 3: Assess your personal net worth

Now it's time to update 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, including:

• What you own, in both your taxable and tax-advantaged investment accounts
• Equity in your home
• Other real-estate properties
• Equity in your business
• Any vested options or employer stock units.

When you're calculating your liabilities, you should examine what you currently owe (a mortgage, credit-card debt and so on) but also what you'll owe if you sell any of your assets. That list of liabilities may include:

• Income taxes on tax-deferred retirement accounts
• Real-estate commissions
• Long-term capital gains taxes
• Loans against other real-estate properties.

Then complete the picture with a statement of personal cash flows—all sources of annual income minus expenses.

If you did all this for 2011, you can compare how your finances performed since then. Did your bottom-line net worth increase in 2012? If it did increase, how did that happen, and by how much? 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.

This is also an opportunity to see if you stayed on track with your savings goals in 2012. Did you max out your 401(k) or other employer retirement plan? Did you still have positive overall cash flow after all your essential expenses, including taxes? If so, how much of that money did you spend instead of save?

Remember, the amount you save is critical to achieving your long-term goals and growing your personal net worth over time. That's why it's smart to budget in your savings target as a non-discretionary line item on your cash flow statement.

Step 4: Make or update your savings and investment 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 funding for children 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 increase your chances of achieving your goal—as you find the right balance between working toward your future goals, including a secure retirement, and enjoying the here and now.

The discipline of financial planning

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 planning, gifting and more—all within the context of the economic, financial and market environment. Remember, too, that planning is not a one-time event, but an ongoing, lifelong discipline.