Investors often compare personal portfolio performance with some stock market index, a benchmark. While the comparison may be easy to make, it is seldom a valid comparison. What we are actually doing is comparing apples to oranges.
Indexes have very little in common with individual investors. Indexes don’t have emotions. They don’t retire. They don’t pay a mortgage. They don’t have to worry about kids or job security, and their time horizon is unbound. Given those significant differences, why do we use a benchmark that has little to do with our investment goals and constraints? Because it’s easy, readily available and constantly quoted by the financial media. But that doesn’t mean we should use it.
A Better Benchmark
So what would be a better benchmark? The first place to start is to clearly define your goals and constraints, and then select a benchmark that reflects those as well. For example, let’s consider the amount of fluctuation in value you are willing to accept. Would you be okay if your portfolio dropped 50%? If not, then a stock index may not be appropriate. History shows they have (and therefore could) move 50% or more to the downside.
Let’s consider bonds. Usually investors buy bonds for safety and income. We don’t expect much fluctuation in principal value – certainly not as much as stocks. Are you prepared to lose 20% or more in the value of your bonds? If not, then an aggregate bond index may not be the best benchmark for you.
Despite the fact that indexes seldom reflect our ability to handle fluctuation, we tend to compare our portfolio performance to indexes, and in a bull market, become disappointed that our portfolio didn’t earn as much as an index (or combination). This may lead us to change our strategy (take on more risk) in search of better results. The new strategy will work well so long as the market cooperates, but once the market turns, investors end up losing more than they thought.
Your Personal Benchmark
Perhaps the best benchmark is the one that is derived from your plan. Such a benchmark is fully customized to you – your goals, constraints and risk preferences.