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How To (And Not) Use Benchmarks To Evaluate Portfolio Performance

You can't help but hear about the frequent ups and downs of the Dow Jones Industrial Average or the S&P 500 index. The performance of both major U.S. indexes is widely reported and analyzed in detail by financial news outlets around the world.

Like the Dow, the S&P 500 tracks the stocks of large domestic companies. With 500 stocks compared to the Dow's 30, the S&P 500 comprises a much broader segment of the stock market and is often considered to be representative of U.S. stocks in general. Both indexes are generally useful tools for tracking large U.S. stock market trends, but some investors mistakenly think of them as benchmarks for how well their own portfolios should be doing.


"...there may not be single benchmark that matches your actual holdings and the composition of your individual portfolio ."


However, it doesn't make much sense to compare a broadly diversified, multi-asset portfolio to just one of its components. Expecting portfolio returns to meet or beat "the market" is usually unrealistic, unless you are willing to expose 100% of your life savings to the risk and volatility associated with stock investments, which is not prudent for most people.

Asset allocation: It's about the entire portfolio!

Just about every financial market in the world is tracked by one or more indexes that investors can use to look at current and historical performance. In fact, there are thousands of indexes based on a wide variety of asset classes (i.e. stocks vs. bonds), market segments (large cap vs. small cap), and styles (growth vs. value). Portfolios are typically divided among asset classes that tend to perform differently under different market conditions. Different asset classes also carry varying degrees of risk and expected future return. An appropriate allocation of stocks, bonds, and other investments should be designed based on your specific financial goals, and then constructed based on your age, tolerance for risk, and the time horizon for meeting your objectives.

Consequently, there may or may not be a single benchmark that matches your actual holdings and the composition of your individual portfolio. A more meaningful approach would be to interrogate each underlying fund or investment position and compare it against an appropriate index based on the areas of the market in which it resides. Still, such comparisons will be imperfect, as specific index holdings and the timing of investment will not precisely match your own portfolio. Even the so-called index funds, which attempt to mirror the performance of public benchmarks have what is known as "tracking error," in that actual portfolio returns are impacted by trading costs and other expenses, as well as the timing of fund rebalancing. Bottomline: It often takes a combination of several benchmarks to provide a meaningful performance picture, and investors should not follow any benchmark blindly.

Keep Benchmarks in Perspective

The desire to become a more disciplined investor is often tested by the arrival of a single negative quarter's financial statement. Since the financial media and many active fund managers promote a belief that there is a way to predict and avoid market corrections, or a method to ​outperform the market without exposing your portfolio to undue risk, many people become anxious during the inevitable volatility that is a hallmark of successful investing. Seasoned investors understand that short-term results often have little to do with the effectiveness of a long-term investment strategy. In fact, it's generally counterproductive to make any investment decisions or portfolio changes based solely on a recent period's performance.


"It often takes a combination of several benchmarks to provide a meaningful performance picture, and investors should not follow any benchmark blindly."


The main problem with making decisions based on recent performance is that asset classes, market segments, or industries that do well during one period don't always continue to perform as well. In fact, they often don't. When an investment experiences dramatic upside performance, it may mean that much of the opportunity for gain has already passed -- at least in the short term. It's also often a mistake to sell an investment when it has experienced a down year, because you will then no longer be in a position to benefit when it starts to recover.

On the other hand, portfolios that are left completely unattended will drift away from the original asset allocation over time. This results in either taking on too much risk or becoming too conservative. Rebalancing periodically to return the portfolio to its desired allocation​ is the simplest way to ensure you are "buying low, and selling high" ​without jettisoning the entire portfolio -- which is rarely a good idea.

Becoming a successful investor -- in fact, becoming a successful anything! -- starts by focussing on what you can control. ​There's really nothing any of us can do to control or predict global economic conditions, future rates of inflation, the tax laws, or the level of returns delivered by the financial markets. What you can control is where the magic happens! This includes the overall composition of your portfolio, diversification, and ensuring an appropriate risk profile. Monitoring performance and then evaluating investment results through the correct lens, using a variety of benchmarks, should also help you make appropriate adjustments and stick to your plan, even when emotions are running high.

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