Why investment goals are more useful than benchmarks
Using benchmarks are an ineffective way to track your portfolio performance unless your entire approach is built around indexes, writes Morningstar's Sarah Newcomb.
I recently heard someone say, “Beat inflation, not the market.” That got me thinking about how important it is to choose benchmarks for judging success that really fit the problem you are trying to solve. This is especially poignant now, since it's December, and many of us are taking stock of our year, looking at our goals and accomplishments, and making plans and adjustments for 2020.
We manage what we measure, adjusting our strategies based on our metrics of success and failure. It’s important, then, to know which measures are truly appropriate and which are red herrings. Looking at your own investment strategy, what is an appropriate measure of success or failure?
Here, I’ll talk about why the overall market is the wrong benchmark, and what will serve you better, based on the current stage of your financial life.
Why measuring against the market doesn’t make sense
It’s easy to compare your annual returns to the returns of the overall market, mostly because you can find market-return information so easily. Every investment platform and news outlet reports market performance practically up to the minute, so the market’s return would seem to be a very important measure and a good way to judge if your own investments are keeping pace. This assumption doesn’t really hold up well under scrutiny, for a few reasons.
First, research has yet to verify a proven strategy for consistently beating market returns, so chasing that goal has long odds to begin with.
Second, if you have diversified your portfolio, you will not always beat the market, because diversification intentionally lowers your risk exposure, meaning that when the market is way up, you will be somewhat up, but when it is way down you will only be somewhat down. You can’t consistently beat the market in both greater gains and smaller losses (see my first point)--and if you can, and you can prove it, please get in touch, because I’d like to see those numbers. The point here is that long-term investment strategies aim at slower, steadier growth over time, so looking at short-term performance (yes, one year is short-term) doesn’t make sense anyway.
Third, the Dow Jones Industrial Average is a measure of the stock values of 30 large companies, divided by a factor that adjusts for stock splitting. The S&P 500, meanwhile, includes those 30 companies plus 470 more. But what do the values of those specific companies have to do with your portfolio? Comparing your investment performance to these benchmarks ultimately answers the wrong question. “Did I beat the Dow?” has little to do with whether or not you are on track to reach your financial goals.
Better benchmarks
The best benchmark is your own, personalised financial goal. This doesn’t need to be performance-based, either. Having a goal to reduce your unsecured debt is just as worthy as a goal to grow your assets. Improving your credit score and establishing a six-month emergency fund are excellent goals.
When it comes to investment returns, your long-term goals should determine your benchmarks.
If you are in the accumulation stage: A long-term investment strategy can’t be properly assessed using a short-term metric. If you are in the accumulation phase of your financial life, then the question you want to answer is, “Am I on track to reach my goals on time?” Losing money--even a significant amount--doesn’t necessarily put you off track, since most investment strategies factor volatility into the plan. That means that you need to expect to have years where you lose money.
Whether or not you are on track is determined by your returns over time, not in one-year chunks. So, rather than looking at 2019’s returns to measure the effectiveness of your strategy, look at the average growth of your accounts over the last five years or so. How does that trajectory look? Unfortunately, there is no premade benchmark for this. You have to do the math yourself or ask a financial adviser to do it, which is probably why so many people just use the readily-available-but-completely-inappropriate benchmarks of the Dow and the S&P.
Some retirement fund providers have added tools to their websites that will estimate if you are on track to reach retirement or not, and these are better than nothing, although very few of them reveal how they make that determination, so I can’t speak to their accuracy.
If you are in the withdrawal stage: If you have reached your accumulation goal and are now in the withdrawal stage, then the question you need to answer is, “Did I beat inflation?”
If you are withdrawing funds at a reasonable rate, then your principal is likely secure, but your money still needs to outpace inflation. Retiring at 65 on an annuity income of $70,000/year may be fine, but when you are 90 that same lifestyle will cost you double. Your assets need to keep pace with inflation or you will have to lower your withdrawal rate as you age, which is not a happy prospect for many.
When market benchmarks DO make sense
The one time when a market measure is actually appropriate is when your investment strategy was specifically designed to track a certain index. For example, if you own an actively managed fund, then it absolutely makes sense to judge its performance against a benchmark, such as the market it invests in. Even so, you will still want to give it more than a one-year stretch before you can truly assess performance.
You’d also want to check for changes in the Morningstar Fund Analyst Ratings of your funds, because those are designed to capture the effects of major material changes in the makeup or governance of a fund. If there has been a downgrade in the fund rating, that should certainly be noted so you can then determine if the fund still fits with your strategy, taking that new information into account.
Likewise, if you own individual stocks, you will want to check in on the Morningstar rating and the price/fair value ratio. Has the fundamental value of the company changed, and if so, does that affect whether or not the company still fits with your long-term strategy?
Overall, the point remains that your strategy should determine the benchmark, and unless your strategy was to track or outpace the S&P, the S&P’s performance is pretty much irrelevant.
The bottom line
Short-term market performance is a red herring that creates a booby trap for investors.
To truly judge the success of your investment strategy, you need to first be clear about your goal, and then choose a measure of success that suits the strategy for reaching that goal.