If you’re like most people, then when you look at your quarterly statements, one of the first things your eyes may go to is the summary of your returns compared to a primary benchmark and two secondary benchmarks. It is human nature to compare ourselves to others, and when it comes to investing, often what we care most about is not how well we are meeting our goals, but how well we are doing compared to (often imaginary) others. For this reason, investors often compare themselves to asset classes that they aren’t even targeting, asking themselves with the benefit of 20/20 hindsight, “Why didn’t I invest in that last year?” That said, surely there is a value in comparing your performance to a benchmark that matches your own asset allocation, if only to make sure that your advisor is doing his job? Even this, however, is not nearly as straightforward as it sounds.
In some cases, if a client has maintained the same basic portfolio target since the beginning of their account, we can readily construct a benchmark that measures how a portfolio composed of those assets should have performed over that period. In those cases, the comparison of your results with the primary benchmark provides an excellent check on how well we are meeting the agreed-upon targets. Typically in these cases, one should expect the actual results to be just slightly under the benchmark line, as indexes are pure mathematical constructs and don’t reflect the real world costs of trading or fund management fees. Sometimes, often when trading fees are minimized due to larger account sizes we are able to outperform these benchmarks despite trading costs. This is generally due to the discipline of our process, in which we are generally buying on weakness and selling on strength, giving us some advantage as market prices revert to the mean.
However, most clients have investment policy statements that change over time, either because their investment priorities have shifted or because their investment strategy is based around a gradually shifting mix of stocks and bonds as they age. In these cases, comparison with a primary benchmark becomes much more problematic. There are three main ways of trying to address this. The first is to try and generate a time weighted average target that captures the overall history of the client’s investment targets. This isn’t terribly helpful as, when viewed on a chart, it will make it appear that the client is at one point substantially outperforming their target, at another point underperforming, when this is really just due to the changing mix in their portfolio. The second is to track your performance only since your last target update, with a benchmark that reflects this latest target. But this gives you little sense of the long-term progress of your portfolio. Finally, we can individually construct personalized long-term benchmarks that capture all of the changes in investment policy statements over time. However, this process is laborious enough that we only offer this service at client request for accounts of over $1 million.
We would be happy to meet with you to discuss your benchmarks and your performance tracking in more detail if you would like, and can customize the benchmarks displayed on your statement upon request. However, in the remainder of this column, we want to encourage you to focus more on the kind of benchmarking that really counts: tracking your performance relative to your own goals.
Indeed, the usual approach to benchmarking encourages a mindset a bit like that of a driver more concerned with how fast all the cars around him are driving than with whether he is on the best route to his destination, and making good progress towards it. The real benchmark that matters is how well are you tracking with your plan to reach your goals. Do you need to save more (probably) or can you afford to relax a bit? Do you need to take more risk to get more return or is now the time to move more conservative to make sure you’ll have the cash flows you need? Are you 95% assured of reaching particular financial goals or would it take a miracle to do so?
This sort of benchmarking is hard to capture on a quarterly statement, and indeed a quarter is too short a time span to assess this well. But you should be concerned to take an annual review of your portfolio to see where you stand in reaching your financial goals. Are you gaining or losing ground? Needless to say, this assessment will include much more than your portfolio’s investment performance—if your portfolio did great, but you only contributed a quarter of the new funds you were planning to in the past year, you may still be well shy of your goals. Of course, all of this presupposes that you have well-conceived, carefully quantified goals in the first place, which many of us do not. These needn’t be complicated, especially for those just starting out in their financial lives. But they should be clear and concrete. In setting up investment policy statements for our clients, and in annual reviews with you, we want to prioritize helping you establish these clear goals, and showing you how well you are meeting the benchmarks you have set for yourself.