Measuring the success of your portfolio is important for several reasons, but most people don’t know how to properly measure the success of their portfolios.
Listen now and learn:
- The purpose of a benchmark for your investment portfolio
- The difference between Portfolio-Based Benchmarks and Goals-Based Benchmarks
- Meaningful questions to ask when evaluating performance
Listen Now
Show Notes
Measuring the success of your portfolio is important for several reasons, but most people don’t know how to properly measure the success of their portfolios.
Generally speaking, most people overly rely on short-term performance, which is problematic because random chance plays a large role in short-term outcomes. Similarly, short-term performance doesn’t necessarily inform you about progress towards your life goals.
In this episode, I’m going to explain a better approach to benchmarking using portfolio-based and goals-based benchmarks.
- A portfolio-based benchmark allows you to better understand your investments, which are the vehicle for helping you achieve your goals.
- A goals-based benchmark helps you measure your progress towards those goals, which is what matters most.
Portfolio-Based Benchmark
The primary purpose of a portfolio-based benchmark is to explain performance.
Benchmarks were not designed to be beaten. Sure, we all want great performance. But if your primary concern is beating a benchmark, then I’d ask:
- Is the benchmark return not good enough?
- Does your financial plan require you to earn returns higher than your benchmark?
If your answer to those questions is yes, then you probably have the wrong benchmark.
What makes a good benchmark? The CFA Institute has identified seven key components of a good benchmark.
Specified In Advance
The first component of a good benchmark is that it should be specified in advance. This means that the benchmark should be well-defined, transparent, and relevant to the investment strategy and objectives.
A specified benchmark provides clarity to investors on what they are trying to achieve, and how they can measure their success. For example, if an investor has a goal to invest in large-cap stocks in the United States, then the S&P 500 index can be a specified benchmark that is relevant to this investment strategy.
Appropriate
The second component of a good benchmark is that it should be appropriate for the investment manager’s style and investment mandate.
This is probably where investors have the most room for improvement.
While it’s obvious that the S&P 500 is not an appropriate benchmark for a bond portfolio, it’s also not an appropriate benchmark for stocks if the manager has a globally diversified portfolio. In my opinion, the S&P 500 is really only an appropriate portfolio-based benchmark when the portfolio or fund is only U.S. large cap stocks.
And yet, so many people compare their diversified portfolio to the S&P 500. I suspect this is partly because US Large Cap stocks have been the best performing asset class for well over a decade, but prior to this period of dominance, US Large Cap stocks trailed Treasury bills for roughly 12 years.
But is a US Large Cap Index appropriate to use when your portfolio owns mid and small cap stocks in the US as well International and Emerging Markets? No, it really isn’t.
It’s not even the best option if you’re seeking to measure how you or your advisor’s U.S. investments are performing…in that case, I’d suggest something like the Russell 3000 Index is most appropriate since it captures about 98% of the U.S. equity opportunity set.
If you’re seeking to compare the performance of an advisor that adheres to a globally diversified stock strategy, then I tend to default to the MSCI All Country World Index, which is designed to provide a broad measure of equity-market performance throughout the world.
It includes large, mid, and small-cap stocks from 23 developed countries and 27 emerging markets, covering approximately 99% of the global investable equity opportunity set.
Measurable
The third component of a good benchmark is that it should be measurable.
The benchmark should be quantifiable, with easily accessible and accurate data that is consistently applied. This allows investors to track and monitor their performance against the benchmark over time.
There are many index providers that have good examples of benchmarks from a measurability standpoint. We’ve already mentioned S&P, Russell, and MSCI. There’s also FTSE, CRSP, Bloomberg Barclays, STOXX, and Morningstar…all of which have indices that can be measured using various performance metrics such as total return or price return.
Unambiguous
The fourth component of a good benchmark is that it should be unambiguous. This means that the benchmark should be clearly defined, with specific criteria for inclusion and exclusion of securities.
For example, the Russell 2000 Index is a benchmark for small-cap stocks in the United States and includes the bottom 2,000 stocks in the Russell 3000 Index.
Reflective of current investment opinions
The fifth component of a good benchmark is that it should be reflective of current investment opinions.
This is my least favorite of the CFA Institute’s benchmark components because it’s a little more vague.
Here’s how I interpret it…
A benchmark is reflective of current investment opinions when the manager has current investment knowledge (positive, negative, or neutral) of the securities or factor exposures within the benchmark.
For example, I don’t have much current knowledge about each specific holding within the Russell 2000 Index, but here’s what I do know:
- The securities represent the smallest 2000 stocks in the Russell 3000
- The companies have a market capitalization of between $30 million and $2.8 billion, have their primary listing on a U.S. stock exchange, and are incorporated in the U.S.
- I believe that, in aggregate, these securities have positive expected returns over the long run.
A benchmark that isn’t reflective of current investment opinions would be something where I didn’t have knowledge of the underlying holdings, methodology, or construction.
Accountable
The sixth component of a good benchmark is that it should be accountable. The benchmark should have an established methodology that is objective, verifiable, and replicable. This ensures that the benchmark is not subject to manipulation and that it can be used consistently over time.
For example, the Bloomberg Barclays US Aggregate Bond Index is a benchmark for the US bond market that uses a transparent and objective methodology to track the performance of a broad range of investment-grade fixed-income securities.
Investable
The seventh and final component of a good benchmark is that it should be investable.
This means that it should be possible to construct a portfolio that closely tracks the benchmark, and the benchmark should be tradable with reasonable transaction costs.
An investable benchmark allows investors to replicate the benchmark’s performance and compare their portfolio’s performance against it. For example, the MSCI Emerging Markets Index is an investable benchmark for the performance of emerging market equities.
A portfolio-based benchmark should be constructed using one or more indices that meet these criteria described by the CFA Institute. And ideally, the portfolio-based benchmarks should also align with the capital market assumptions of your financial plan.
If you do those two things, then I think it is easy for a benchmark to fulfill its primary purpose of explaining performance.
Explaining performance is a big deal because when you building a portfolio that is different than the benchmark, naturally that means performance will always be above or below the benchmark.
But a good benchmark will allow an investor of any experience level to notice differences in risk and return, which in turn allows them to ask reasonable questions, such as:
- Why did we deviate from the benchmark?
- Is this type of deviation normal or is something wrong with the strategy?
- Are we taking too much risk to earn these returns?
- How do fees impact the performance being reported?
- Is there a cheaper way to access these exposures?
Goals-Based Benchmark
While a portfolio-based benchmark helps you better understand your investments, a goals-based benchmark focuses on your progress toward meeting your life goals.
This requires having a clearly defined set of goals, such as paying off a mortgage, funding children’s education, or maintaining your lifestyle through retirement.
By using a Monte Carlo analysis that runs thousands of scenarios, you can generate a probability that your financial plan will be successful. By setting a target probability for success you establish a goals-based benchmark and create a more meaningful framework for evaluating market movements as they relate to your personal situation.
When markets begin to fall, people tend to look at their portfolio before anything else.
However, reviewing the underlying assumptions of your financial plan would be a better course of action because a thoughtfully crafted financial plan takes those periods of bad performance into account, and does so without emotion.
The goals-based benchmark allows you to ask questions about your portfolio in the larger context of your life goals.
- How does this recent market movement impact my goals?
- Am I still on track?
- Should I be doing something differently?
Resources:
We all need to understand our money and what to do with it. If you’d like to learn more about our process at Plancorp and how we help clients measure the success of their portfolio, you can learn more here:
- How to work with me
- The 8 Essential Elements Of A Complete Financial Plan
- FREE GUIDE: Pursuing A Better Investment Experience
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About the Podcast
Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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