Wednesday, February 20, 2013

The Importance of Benchmarks

I’m a big believer in comparing your portfolio returns to appropriate benchmarks each year. Passive investors need to know if their investments are really tracking the indexes they are supposed to track. Active investors need to know whether their strategies are winning or losing.

I was throwing out some old papers and came across an article in a BMO Investorline “Best of the Best” magazine that mentioned both benchmarks and the importance of controlling costs. I was a little surprised by this because a focus on costs and benchmarks would push most investors to cheap indexing strategies that would lower BMO profits.

The article discussed “minimizing the costs―management expense ratios (MERs), commissions, etc.―associated with investment selections.” I’m impressed with Investorline for highlighting costs as an important factor in choosing investments.

Comparing portfolio returns to the right benchmarks is important as well. If you’re losing to a simple indexing approach year after year, maybe it’s time to give up on trying to beat the index. Unfortunately, few investors compute their returns and compare them to indexes. A study by Glaser and Weber showed that investors overestimated their own past returns by over 11%, on average. So, if you don’t measure your returns but you’re pretty sure you’re doing well, maybe you should knock 11% off your estimate of your portfolio’s yearly return. Or better yet, start measuring your returns.

The Investorline article had a sidebar titled “The Importance of Benchmarks.” Based on the title alone, I thought this was another example of their willingness to give investors useful information, even at the expense of their own profits. After all, if more investors knew just how badly their portfolios were performing, many would find their way to low-cost indexing.

Unfortunately, the article used a definition of “benchmark” that I hadn’t seen before in connection with investing. Apparently, benchmarks are measures of allocation to stocks vs. bonds, concentration in geographies, allocation to growth vs. value, and other measures of diversification. These are important things to consider, but when it comes to investing, I prefer to reserve the word “benchmark” to mean a measure of how a passive portfolio with a given mix of assets performs. Then active investors can see whether their investing strategy is winning or losing against a passive do-nothing strategy.

3 comments:

  1. Interesting -- your phrase "a passive do-nothing strategy" reminds me of the risk-free rate when it comes to calculations such as time value of money. It makes no sense to consider money at its nominal value indefinitely; if you're going to consider a certain risky course of action, it makes sense to evaluate your success on what you could have achieved with no risk.

    Similarly, if you're considering a labour-intensive course of action, it makes no sense to compare it to cash under your mattress. It makes sense to compare it to a labour-free rate of return.

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    1. @Patrick: Interesting analogy. There is even a continuum between these two end points. Whatever risk-level one takes on with a labour-intensive method of investing, there is a corresponding labour-free portfolio with the same risk that is a good basis of comparison.

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    2. Wow, that is pretty interesting. Minimizing labour gives new a new twist to the concept of the "efficient frontier" in modern portfolio theory.

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