Benchmarking

Some say that comparing your portfolio’s returns to an appropriate benchmark isn’t important as long as you’re meeting your financial goals. This sounds very reasonable, but whether or not it makes sense depends on the situation.

Situation 1: An investor saves all of her money in GICs. She could be making more over the long term by owning some stocks, but she is saving enough that she is meeting her financial goals. Is this sensible?

With a couple of caveats, I’d say yes. Many investors, particularly GIC investors, don’t think enough about inflation. If you’re about to retire and your GIC portfolio is producing the amount of interest income you’d like to spend, then you could be disappointed in future years as inflation erodes your savings and your income. As long as our hypothetical investor takes into account inflation and possible interest rate changes, she should be fine ignoring the stock market. I prefer to go for the near certainty of an earlier retirement from decades of investing in stocks, but to each her own.

Situation 2: An investor has all his savings in the IG AGF Canadian Balanced Fund, paying total fund fees of 2.89% each year. He prefers not to compare his returns to a blended benchmark of Canadian stocks and bonds because his portfolio seems to be progressing acceptable well.

This investor’s reasoning doesn’t make sense. He is giving away a substantial amount of money each year. If he doesn’t need high returns, he could have a much less risky portfolio that gives more stable returns. With a DIY approach, he might be able to get the same expected returns without any stocks at all. By finding another advisor who chooses funds charging 2% or less each year, he could significantly lower his stock allocation. His current path has him taking equity risk but giving away much of the equity premium. His future returns are expected to be low, but his retirement hopes could still be dashed by a stock market crash. He’d be better off to compare his returns to a benchmark, see the problem, and either go for a less risky portfolio or choose to keep more of the equity premium.

Situation 3: A stock picker prefers not to compare his returns to a benchmark. He says the benchmark isn’t relevant in his case.

This investor’s reasoning doesn’t make sense. He needs to know whether there is something wrong with his stock selection process. It’s true that comparing his returns to the wrong benchmark gives no useful information. For example, an investor who chooses Canadian stocks learns little by comparing his returns to the S&P 500. A Canadian dividend investor would do well to compare his returns to that of a Canadian dividend ETF. Consistently underperforming this ETF could be a sign of making poor stock selections. The challenge for each investor is to honestly seek out an appropriate benchmark. It’s always possible to find a benchmark that had a bad year to make personal portfolio returns look better. It’s best to choose the benchmark beforehand and try to make an honest assessment of whether your stock selections are really doing you any good.

It’s true that past returns are no guarantee of future returns. However, we are looking at the gap between our returns and that of a benchmark. When the benchmark is chosen well, this gap has some predictive value. The investor with his money in the expensive balanced fund has past underperformance that is likely to persist into the future. A poor stock picker is likely to remain a poor stock picker, particularly if he isn’t aware that his efforts are losing him money.

For stock pickers who prefer to protect their egos from an objective measure of their real skill level, I have a checklist of best practices.