How do you know if your investments are behaving as they should? Are you on track to achieve your objectives? The idea behind a benchmark is to measure your own progress and compare it to some standard. Then you can measure effectiveness and take appropriate action.
Here are three ways of answering this question, for which you can use entirely different benchmarks.
a. Benchmark: S&P 500 Index. Here you could compare your own portfolio to this unmanaged market-value weighted average of the prices of the 500 largest companies traded on the NYSE, AMEX and NASDAQ exchanges. You can compare price appreciation, i.e. performance, return. You can also compare drawdown, i.e. maximum decline from the peak, a measure of risk. With this benchmark you can evaluate your investments from the standpoint of growth and safety - do you have the right mix for your situation and risk tolerance?
b. Benchmark: a mix of indexes that parallels the mix in your own portfolio. For example, if your portfolio is a mix of 40% US stocks, 20% foreign stocks, 35% US bonds, and 5% cash, then your benchmarks could be a mix of the S&P 500 Index for US stocks, the EAFE Index for foreign stocks, an Index of long-term bonds, and the Consumer Price Index for cash - in the same proportions. A benchmark of this type could help you evaluate the effectiveness of your money managers in selecting individual investments. The more closely this benchmark parallels the composition of your own portfolio of investments, the better it will work for this purpose.
c. Benchmark: your own goals. For example, let's assume that you had estimated that you needed to save 12% of your income and have your investments grow at a 7% rate in order to be "on-track" for retiring or being financially independent in 7 years. You should compare what has happened with what you had hoped to happen. This comparison will give you some ideas about your choices, progress, and changes you need to make.
Here are some key questions to ask yourself as you establish benchmarks:
• What do you really want to accomplish, before you go to the trouble of monitoring progress?
• What can you control and what not?
• Will a proposed benchmark be appropriate for answering the questions you have and guiding you to take the right actions?
Remember, investors cannot directly invest in indices, and past performance does not guarantee future returns.
Leave a comment