Growing up the youngest of three children was certainly an adventure, always having built-in babysitters, usually embracing the role of punching bag, and learning every sport my siblings took up were just some of the “perks” of being the youngest. In almost all aspects of life, especially sports, my comparison, or benchmark, would always be my five-years-older brother.
From how far he could throw a ball, how fast he could run, to how high he could jump, keeping up with his skill level in anything was a constant uphill battle.
For those with siblings you understand the constant benchmarking against each other for who can do what the best. Thankfully as we matured and our sports days quickly faded in the rearview mirror of life, our comparing subsided (that’s not to say we have dropped our competitive nature completely).
Most can agree that comparing how fast a five-year-old throws a baseball to the speed of a ten-year-old is not the correct sample for either. The same can be said for those trying to build their wealth through investing. A risk-averse individual investing primarily in fixed-income, or low risk vehicles, will be in a constant uphill battle with someone invested primarily in stocks or other riskier products.
While the end goal of ‘make this money grow’ is the same, the means of achieving that goal is different for almost everyone. Choosing the correct benchmark for your portfolio can ultimately lead to a healthier lifestyle and significantly increases the odds of achieving financial goals.
There are a few different benchmarks, also referred to as indices, which investors can choose from when assessing portfolio performance. Rather than listing the hundreds of various indices available, below is a list of five of the most widely used benchmarks for investors.
Standard & Poor’s 500 (S&P 500)
Includes 500 of the largest market capitalization-weighted publicly traded companies in the US. The weighting for each company is calculated by the company market cap divided by the total of all market caps.
Dow Jones Industrial Average (DJIA)
Includes 30 large, blue chip companies with consistent earnings that are listed on the New York Stock Exchange and the NASDAQ.
Includes 2,500 global equities listed on the NASDAQ stock exchange, including American depositary receipts, common stocks, real estate investment trusts, tracking stocks, and limited partnership interests. The index is market capitalization weighted.
Measures the performance of roughly 2,000 of the smallest capitalization US companies, weighted by market-capitalization.
Bloomberg Barclays US Aggregate Bond (the Agg)
Used by traders investing in bonds that includes government securities, mortgage-backed securities, asset-backed securities, and corporate securities. The investments included are all investment-grade or better and are over one year until maturity.
Clearly there is a wide range of options when determining the best fit. While I am no car junkie, an example might help visualize the importance of choosing the correct benchmark. Take for example a race between two cars. At top speeds a Toyota Camry would always be trailing a Porsche, probably finishing the race well-behind, but still able to finish the race. The Camry would be deemed ‘slow’ while the Porsche would clearly be ‘fast’. But if a Camry were matched against a Honda Accord, the Camry might win and be deemed ‘fast’. Similarly, if a Porsche were to race a BMW, the Porsche might end up finishing behind and be labeled ‘slow’.
Going further into the details is the risk involved at the top speed of each car.
A Camry and an Accord have the same relative risk, as do a Porsche and a BMW, but the risk involved at the top speed of a Porsche is much greater than that of the top speed of a Camry. While it is easy to become caught up in labeling the different choices as ‘fast’ or ‘slow’, the paramount detail in this analogy is that the cars all finished the race at their relative level of risk. Putting yourself in the driver’s seat of those cars can answer the question of how much risk you are willing to handle—could you tolerate the stress at the top speed of a Porsche or BMW, or would you prefer the Camry?
Relating this to investing is as easy as answering ‘What amount of risk am I willing to endure to reach my end financial goal?’ If your portfolio is aggressively invested in stocks, then the appropriate benchmark would be one that matches the risk in your portfolio. On the other hand, if your investing strategy is closer to conservative, then a conservative benchmark would be suitable.
A trusted financial advisor can help set realistic expectations for which benchmark to use when reviewing one’s individual portfolio performance. Along those same lines, it is helpful to have the guidance of a professional to manage expectations of an investment portfolio.
Just as a driver of a Camry can quickly become envious of a Porsche, a conservative investor can become envious of returns produced by an aggressive allocation. But, if the underlying risk of the aggressive portfolio is too much to handle through volatile periods, it could be necessary to shift allocations and behavior to be more tolerant for your individual needs. The end goal is to finish the race, but there are many different paths to the finish line.
Do you have questions about benchmarking your investments?
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