Thursday, June 23, 2016


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.


  1. You'd also have situations like mine: I've always been an indexer, and while I haven't executed perfectly I also know I couldn't be much more mechanical in my execution, so any difference between an appropriate benchmark and my real numbers wouldn't mean much - there isn't much I could do to improve or streamline how I operate.

    1. @Anonymous: Assuming you're not doing any market timing, there's not much benchmarking you can do. But you can still check on the tracking error of your funds or ETFs.

  2. I have been an indexer for a long time. I used to own a lot of US blue chip stocks in the old days.

    Then I switched to indexing. I was sold on the idea that I am dumb, and do not know anything. The idea of a whole world index portfolio also made sense to me. I was sold on the idea that I have home bias to the US.

    So I ended up selling all of my individual stocks and bought VT - the vanguard total world ETF.

    This decision cost me several hundred thousand dollars. Instead of having a net worth of close to $1 million that I would have, had I stayed with US stocks only, my net worth is roughly $650,000.

    I have noticed that I would have been better off holding on to those individual blue chip stocks. International stocks have done much worse than US stocks.

    So while my index funds did as well as my benchmarks, my active picking of asset classes cost me dearly.

    In fact, even holding bonds would have been better than picking stocks. The whole idea of ignore everything and just buy indexes is very dangerous.

    As a result of using indexing, I will have to work for 5 – 10 long years, before I can reach retirement. Unfortunately, my health is failing, and as I am aging, my mind is not as sharp as it used to be.

    1. @Index Investor: It sounds like your investments have not worked out the way you hoped. I'm trying to follow your story. Switching to VT got you to $650,000 today. Are you saying that if you had switched to VTI instead, you'd have close to $1 million? I'm not sure what you mean by "my active picking of asset classes cost me dearly." I don't think buying indexes is dangerous. However, it is guaranteed not to give the best possible results. There are always other choices that would have made more money (U.S. stocks in this case), and a great many choices that would have made less money.

      $650,000 is quite a lot of money. You might consider cutting back your lifestyle instead of working another 10 years, particularly if your health is failing (assuming you continue to have health coverage).

  3. I avoid the stock market casino as much as possible.

    Everyone has an incentive to sell me mutual funds and index funds. These “helpers” are motivated by commissions, not by helping me. As a retiree, my goal is not to hug any benchmark but to stay retired. Most who sell mutual funds are not retired – they earn their money selling you advice or products.

    I retired in 1994 at the age of 36, after selling my business. I retired with 500,000 in long-term real return government bonds and a fully paid off house.

    I was earning roughly 23,000 - 25,000 in annual interest income, which has been adjusted for the rate of inflation over time. My family lives within its means, and we usually have some money left over to add to our bonds.

    I sleep well at night with my allocation. I have avoided the dot-com bubble, the global financial crisis and whatever the next crisis is going to be.

    I am glad I never trusted the stock market. Most stock market investors lose out big when things get tough, and end up selling low. My bond returns are probably better than that of most stock market investors.

    1. @Robb: I don't see the stock markets as a casino, but I can understand why it can look like one. I see the index fund units I own as my tiny slice of the profits of innovation all around the world.

      That said, there's nothing wrong with taking a lower risk path if you have enough to cover your expenses. If your real return bonds were to last the rest of your life, it seems that you'd be fine. However, you bought them 22 years ago. Do you know when they will mature? The juicy 4.6%-5% real return you're getting now will end. Today's rates on real-return bonds is tiny. You could be in for a shock soon. At only 58 now, I doubt that a 5% withdrawal rate will be safe for you no matter how you choose to invest.

    2. Innovation at several hundred times earnings? No thank you. You may be the one in for a shock, after your index portfolios deliver no returns for long periods of time. You will do as well as your benchmarks, but you will likely not earn much in returns. I would bet that my bond only portfolio has done much better than yours, while letting me sleep well at night.

      And why would I be in for a shock? Are you suggesting that I am not aware of the current situation in the bond market around the world?

      As my bonds mature, I will extend my RRB ladders. Some will mature in 5 years, others will mature in 10 years, and another batch will mature in 15-20 years. It is not a problem that I will be earning zero real returns, as I will be slowly eating my principle. Isn't this what most index investors do anyways - they eat 4% of their principle?

      I assume, at ages 63 - 68 that I am unlikely to live for more than 40 years. So I have that amount, plus I have a fully paid for house ( which has appreciated nicely, though the bubble could pop at some point)

    3. @Robb: If you've been following the bond market and have a plan, that's good. I had some relatives years ago who bought long-term bonds in the early 1980s, lived off the interest, and had no idea their income would be cut to one-quarter. It wasn't pretty because they didn't know it was coming. They could easily have handled it if they were more aware.