“How am I doing?”
That question was famously asked by 1980s New York City Mayor Ed Koch, but it’s likely one that you might — and should — ask yourself concerning your finances.
To gauge the performance of your stocks, bonds or mutual funds, you might check major stock indexes daily. Or perhaps you’ll turn to your smartphone for the latest moves in the bond market. But that can steer you wrong when it comes to saving for the future. Why? Everyone has their own personal savings goals, their own financial challenges, and their own financial needs.
All that really matters? The Benchmark of You.
That benchmark lies somewhere in the intersection between your savings objectives (retirement, education, a new car), the performance of widely-accepted benchmarks (the US Standard & Poor’s 500 index, the DAX, the price of gold and more) and your investments. While it can be challenging to define your personal sweet spot in the middle of these priorities, it is a valuable exercise.
Understanding the Benchmark of You, or your blended benchmark, if you prefer, can relieve you of some of the daily angst of watching the market. It can also steer you to smarter investments and less short-term thinking.
Whether you actually build the Benchmark of You or just use this exercise as a way to see your investments — and your risks — in a new light, the process should help you focus on an understanding of your personal financial goals.
To get started, first focus on your asset allocation, and how different mixes of stocks and bonds influence future potential returns and current income, said Fran Kinniry, an investment strategist for the Vanguard Group. This is important for gauging the risk of your investments.
For example, stocks pay dividends but can also be very volatile. They increase/decrease based on the market’s view of future earnings. Bonds pay interest and return principal, but with some exceptions, are not particularly effective in times of inflation. Precious metals just sit there.
In most cases, if you hold broadly diversified portfolios and don't try to time the market by trading, your risk and return will depend almost entirely on your asset mix and costs. “Once you’ve identified your asset allocation, then work down to make sure the benchmarks make sense: domestic stocks, foreign stocks, taxable bonds…etc,” said Kinniry.
If 10% of your portfolio is invested in US small cap stocks, then you should identify an appropriate benchmark index — such as the Russell 2000 — and make note of how that index does on a daily basis.
Two notes of caution before starting this exercise: The more individual stocks, bonds and funds you throw into the mix, the more benchmarks you may have to track. Also, remember to account for fees. They vary, depending upon the investment, and can diminish your overall performance.
Here’s how you might go about pairing your investments with the appropriate benchmarks on the way to the Benchmark of You.
1. Start with your stocks and bonds: Identify the industry or sector in which the security would be grouped. Then, you need to locate an index (or low-cost index fund) that closely corresponds with that security. Be careful, some companies may be hard to categorize. In some taxonomies, internet retailer Amazon.com is considered a “Services” business in the “Catalog & Mail Order Houses” industry. Apple is a “Consumer Goods” business in the “Electronic Equipment” industry.
In the end, you are trying to match up your individual holdings with indexes that represent the industry the company is in.
2. Then move to your mutual funds: You want to find which benchmark by which that fund is measured. (Most openly disclose this in the prospectus. Read it.) At the same time, make sure you understand the strategy of the fund. If it is an index fund, what is it trying to do? Is it tracking a traditional market-cap weighted index, which holds each company in an index according to its market weighting like the S&P 500, or is it trying to make a risk-return trade-off with different weightings and different sector exposures? All funds, index or not, disclose their objectives and what index or composite they are attempting to match or outperform. Data providers like Morningstar and Lipper can also provide some context by placing a fund in a peer group and comparing it against an index.
Some funds have split personalities. An “unconstrained bond fund” invests in anything with a coupon payment. A balanced fund may be 60% stocks and 40% bonds. There are dozens of flavours of hedge funds. Once you know what index your fund is trying to beat or match, track that alongside the fund quarterly and annually.
3. Pulling it all together: Once you’ve matched up all of your measurable investments to indexes or index funds, you can do one of two things. The simple solution is to track the total return of the indexes (or index funds) against your own holdings on a one-to-one basis. Size up the discrepancies quarterly or annually, whenever you rebalance your portfolio.
The more complicated solution is to use an online portfolio tool at Yahoo Finance or Morningstar and create a “dummy portfolio” invested in index funds in proportion to your own stocks, bonds and funds. It gets even trickier when you want to rebalance or reinvest dividends. Unless you really want to manage your “dummy portfolio,” stick with option 1.
Vanguard’s Kinniry cautions, however, that a blended benchmark can be distracting and lead to performance chasing.
“If there’s a lot of volatility to your performance, overall and above or below the benchmark for each investment, then either you are looking at the wrong benchmarks or you are taking more risk than you expected,” said Kinniry.
And for those who are still out there gunning to beat a benchmark, just bear in mind that a majority of investment funds can't consistently beat their own benchmarks.