One of the most important aspects of becoming a better investor is to evaluate one’s performance. However I do not think an absolute performance is the right way to do it.

For ex: If one’s stock portfolio returned 2% during the period 2000- 2003, I would consider it to be a superior performance than a 30% increase from 2003-2006. The reason is that during the period 2000-2003 , the market lost more than 30%, whereas during the period 2003-2006 the market almost doubled.

I evaluate my own performance as follows

I use the following formulae to evaluate the performance on my stock portfolio. I am not referring to a single stock, but for the entire stock portfolio.

Return = End portfolio amount – starting portfolio amount – cash added (or removed)/ starting portfolio amount

The period for the above formulae can be a month, quarter or a year. I prefer to evaluate the performance annually.

I compare this performance with the following three benchmarks. You can look at these benchmarks as three rising levels of hurdles to be crossed.

Level 1 – No risk FD return – This is the return I get from investing in bank FD. The stock portfolio has to cross this level. Otherwise I am way better off investing in FD’s and going off to sleep.

Level 2 – Index fund return – This is the return one can get by investing in the index (NSE or BSE) via ETF’s or index funds. The stock portfolio has to outperform this level, other wise I am better off investing in an index fund.

Level 3 – Mutual fund return – I referred to it in my previous post. My stock portfolio return should exceed the return I get from my portfolio of mutual funds (post expenses). If not, then I am again better off handing my money to the fund managers and doing something better with my time.

A caveat – One should not make a decision based on a single year’s return. In a single year, the stock portfolio returns can be volatile and even be below level 1 benchmark . I prefer to look at rolling 3 year returns to reach some tentative conclusion. I would prefer to look at the results of atleast 5 years before reaching a conclusion that I have crossed each of the above benchmarks. For a 5 year period, one should look at the cumulative returns from the stock portfolio and compare it with the above 3 benchmarks. Only if one has done substantially better than the three benchmarks, can one conclude that he or she ‘may’ be a superior stock picker.

The above may sound harsh and pompish. But I think if one has to be better investor, honest appraisal of one’s performance is important. If I have five duds and my portfolio returns less than what I could get in an FD, then there is not much to be gained from a stock pick which doubled in 15 days. I may have bragging rights and may feel smart, but I am not being honest and objective about my performance.

I posted the reply from warren buffett on the above question. The key takeaway from his reply is that one should read a lot and invest your own money based on your ‘own’ ideas and analysis.

I will touch upon my approach to improve myself as an investor in this post.

I have been reading various investment related books, articles and annual reports for some time now. However my approach to it was disorganized and did not have any pattern to it. However in the last 2 years I have developed a plan to read with specific goals in mind.

I look at reading with two key objectives

1. Find new ideas (which are profitable)
2. Develop mental models to become a better investor (read this article from charlie munger on mental models)

I have broken the second objective into the following topics (related to investing)

Finance – topics such as Balance sheet, income statement, various ratios, analysis of these statements etc
Accounting – understand various accounting concepts and standards
Valuation
Competitive advantage and strategy
Probability and analysis of risk
Study of business models
Economics – mainly micro economics
Investing – value investing
Options, derivates and other financial instruments

I have better knowledge in some these areas relative to other topics. For example I have not read much on options and derivatives till date. Somehow I get put off by all the math in it (although I am engineer by background 🙂 ).

So at the beginning of the year I try to assess myself on these areas and try to identify the specific areas on which I would focus. For ex: I am currently focussing on topic 4 – competitive advantage. I identify books for this topic and add it to the list of books I would be reading over the course of the year. I run through all the topics in this manner and try to come up with a tentative book list for the year. This is not a list set in stone. If I find a better book for the topic I am interested in, I end up replacing it with that book.

In addition to the above book list, I have also listed the industry groups I would be focussing on this year. Currently my focus is on pharma. I have shortlisted around 5-6 industry groups for the year (see my industry analysis spreadsheet here). To improve my knowledge in a particular industry (related to topic 6), I read up on the annual reports of some of the top few companies in the industry. In addition, I try to read up on industry reports if I can get access to them for free.

This industry group analysis activity helps me in increasing my circle of competence and also helps me in coming up with new investment idea. Finally as all knowledge in investing is cumulative, I can easily use this knowledge again later to come up with good investment ideas.

Finally I run valuation screens and if I can get some undervalued candidates, I read up on them. This is more haphazard as I may get candidates in industries which I have no prior knowledge. However it is a good starting point in those cases. If the candidate is in an industry in which I have done some prior study, then the analysis is faster.

The last step is – as they say on shampoo labels – rinse and repeat. That is I keep repeating the above process. Ofcourse the books, the topics and the industry groups keep changing, but the approach is the same. This approach has been helpful as it keeps me focussed on areas which i need to improve and also to enhance my circle of competence