Benchmark your investment performance

Investors should compare their investment performance against an appropriate market benchmark. Let's take a look at why and how to do it.

Benchmarking refers to setting reasonable expectations for investment performance using broad market indices. Many investors will instinctively look at the performance of the S&P 500 Index or, worse, the Dow Jones Industrial Average (DJIA), and wonder why their portfolio is not producing the same returns. It may be because their expectations are misplaced.

In most cases, investors have multiple asset classes in their portfolio, making an all-U.S. stock benchmark an inappropriate measure. Even if the portfolio is all stock, an all-U.S. benchmark is not the best measure of performance if the portfolio includes foreign stocks. And even if it is an all-U.S. stock portfolio, the S&P 500 and the DJIA may not be good fits. The S&P 500 excludes small-cap stocks and the DJIA represents only 30 major stocks out of a market of several thousand companies.

To be useful, a benchmark needs to accurately reflect the asset classes in the portfolio. Most often that will require a blended benchmark of several market indices starting with stocks and bonds and possibly including others such as commodities or real estate. Also, benchmarking performance will only be meaningful if you can compare it with your own portfolio performance-presupposing you are correctly measuring your investment returns, a topic we have previously discussed.

The most fundamental reason to use a benchmark is to see how you are doing against a reasonable set of expectations and whether you could do better. Is your portfolio construction sound? Are you getting what you are paying for?

A blended benchmark should be assembled starting with broad market indices for the major asset classes in the portfolio. The selection of a relevant index requires informed judgment to match the investor's investment allocation. The following are examples, not recommendations, because for each market segment there are multiple indices to choose from, often with subtle but important distinctions.

For the U.S. stock market, options include the Russell 3000 Index, the S&P 1500 Index or the Dow Jones U.S. Total Stock Market Index. If the U.S. stock holdings are primarily large cap stocks, then the S&P 500 might be fine. For international stocks, options might include the MSCI ACWI ex USA, a Morgan Stanley Index, or the FTSE All-World ex U.S. Index. However, if you wish to exclude emerging market stocks, you will need to use alternatives such as the MSCI EAFE Index or the FTSE Developed Ex-North America Index.

For bonds, the Bloomberg Barclays U.S. Aggregate Bond Index is a widely followed broad market index, but if the portfolio includes foreign bonds or holds primarily U.S. government bonds, then other options should be considered.

Another judgment call is how specific or granular the blended benchmark should be. There are indices covering virtually every sector and niche of the economy, but you run the risk of creating a blended benchmark with so many components that it no longer conveys how you are performing against the broad market. In most cases, three to five component indices should be sufficient. Fewer components may sacrifice a bit of precision, but it probably yields a more meaningful comparison against the broad market.

Once you have identified the benchmarks appropriate for your portfolio, you will assign them weights that correspond to your strategic allocation targets. If you hold, for example, a 60% stock and 40% bond allocation, your blended benchmark might look like this: 45% Dow Jones U.S. Total Stock Market; 15% FTSE Developed Ex-North America; and 40% Bloomberg Barclays U.S. Aggregate Bond Index.

Be realistic when comparing your performance against a benchmark. It is only one factor to consider when evaluating your investment performance and should not be treated as a simple pass/fail scoring.

Market indices are theoretical constructs and not actual investments. They report theoretical market returns without the impact of fees, taxes or other expenses. Over time, investors should expect to underperform the benchmark performance simply due to the costs of investing.

If you consistently exceed the benchmark performance, then you are (or your fund manager is) either an unusually gifted investor (or very lucky) or your benchmark is wrong. The latter is more likely the case. If you are consistently underperforming the benchmark performance by much more than the costs of investing, then either you are not as smart as you think, you are very unlucky, your benchmark is wrong or you may be paying too much.

If you work with an investment adviser, you should be tracking the rate of return for your portfolio. In addition, you should consider asking for an appropriately blended benchmark so that you can compare your performance with the theoretical market return that matches your allocation. Unless you can measure how you are doing, you will not know how you might do better.

Shine some light on these numbers.

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David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. david@worthconsidering.com.

Published: Fri, Nov 17, 2017