Part 1: Benchmarking
A four-part series that illuminates the purpose and limitations of benchmarking, incorporating a personal perspective on my investment portfolio.
What is Benchmarking?
Benchmarking is a fundamental concept in the world of investing, serving as a compass for investors to navigate the performance of their investments. It involves comparing a portfolio's returns to a standard or measure, typically an index, to gauge its success or areas needing improvement.
A benchmark is essentially a yardstick against which the performance of securities, mutual funds, exchange-traded funds (ETFs), or entire portfolios can be measured. These benchmarks are usually indexes that represent a segment of the market or the market as a whole. For example, the S&P 500 is a widely recognized benchmark for large-cap U.S. equities.
Why is Benchmarking Important?
Benchmarking your portfolio can be a valuable exercise, but it’s important to understand its purpose and limitations. Here are a few points to consider:
Performance Comparison: Benchmarking enables the comparison of your portfolio's performance with a standard or 'benchmark.' This standard could be a market index, such as the S&P 500, or a tailor-made benchmark that mirrors your investment approach.
Risk Assessment: It can assist in evaluating the risk taken in comparison to the benchmark. Should your portfolio exhibit significantly greater volatility than the benchmark, it may indicate an excessive level of risk.
Strategy Evaluation: If your portfolio consistently underperforms the benchmark, it might be a sign that your investment strategy needs adjustment.
Limitations: Benchmarks are imperfect. They fail to consider personal objectives, risk appetite, or the time frame for investments, among other factors. Moreover, they do not account for the effects of fees and taxes on investment returns.
So, is benchmarking a worthwhile task to undertake?
Certainly, but don't be overly concerned. Keep in mind that you have your unique investment style and objectives. If you believe it's the best fit for your needs, then that's what matters. Your approach is your own choice and should not be subject to criticism. Naturally, this doesn't exempt you from making poor investment decisions. Yet, those decisions should align with your investment preferences and priorities. Consequently, any analysis to measure your performance should closely reflect the investment style and goals you adhere to.
How to Use Benchmarks?
When benchmarking, it's advisable to select an index (or a combination of indices) that closely matches your strategy. This could be determined by sector allocation, geographic distribution, investment duration, or type of asset risk. Such alignment can provide a clearer indication of whether you are surpassing a comparable strategy, which is crucial since time equates to money.
Additionally, you can refine your portfolio according to your investment style. For instance, if you chose a technology or utility stock that underperformed while there were better-performing alternatives in the same sector, it's an opportunity to reassess, comprehend the reasons behind the suboptimal choice, and make necessary adjustments for the future.
Alternatively, if you choose to ignore benchmarking entirely, concentrate on your ultimate objective. Is it to achieve a specific milestone, like buying a house or a car, or is it simply to attain a certain amount of savings? Perhaps it's to secure an additional income stream for retirement? Clearly define your goal and proceed accordingly.
Conclusion
Benchmarking is not just about chasing the highest returns; it's about understanding the context of those returns. By using benchmarks wisely, investors can strive for a balanced portfolio that aligns with their goals and risk tolerance.
Ultimately, enjoyment is key. If you lack the knowledge to be an active investor or aspire to that level, this approach may not be for you. Instead, educate yourself about index funds and consider investing in them. Relax and allow the indexes to work on your behalf. However, for those who are informed and confident about where they invest their money, why settle for an index fund when you might disapprove of many equities it contains, not to mention the fees? Consider constructing your own portfolio to eliminate underperformers. It's challenging, but commitment and thorough research are essential. The investment world abounds with opportunities, and there's no universally right strategy. You must be prudent and comfortable with your investment choices.