- What a portfolio benchmark is
- Why benchmarks are important
- How to compare your portfolio to the right benchmark
No one would ever be upset with a 10% return on their portfolio…right? That is unless you ask the question how well should I have done? You’ll never be able to tell how your portfolio is truly performing if you don’t have something every portfolio needs: a benchmark.
“Did your portfolio beat the benchmark?” “…Did my portfolio beat the what? My portfolio returned 10% last year, that definitely beat what I used to get in my savings account.”
Benchmarks are a constantly neglected aspect of investing. They put returns under a microscope and make you take a critical look at your yearly return. And, with our busy lives, as long as your portfolio has a positive return, who cares what could’ve been. C’est la vie.
But like anything in life, you want your portfolio to improve and make sure its doing the best it can to reach your financial goals. And a benchmark can put your portfolio’s returns in perspective, so it’s about time someone explained them.
What is a benchmark?
According to Investopedia, a benchmark is a standard against which the performance of a security (stocks, ETFs, etc.), mutual fund or investment manager can be measured. In everyday investor speak, it’s something to compare your portfolio performance against. For instance, if your entire portfolio was made up of Apple stock, looking back on a full year (ending March 31, 2018) you would’ve made 16.8% return on your investment. On paper, that looks great, who wouldn’t want a 16.8% yearly return? But the real question is: Did you (or your advisor) have a great insight and picked Apple to outperform all other tech stocks, or did you just benefit from an overall rise in the market?
A benchmark answers this question.
A typical benchmark for Apple stock could be the S&P Information Technology index. Why? Because this index not only includes Apple but also tracks all of the technology stocks in the S&P500. So it allows you to compare Apple to the entire technology sector.
The one year return of the S&P Information Technology Index (as of March 31, 2018)? 26.0%
So while your Apple return looked great on paper, you really missed out on over 50% greater returns if you simply bought every technology company listed in the S&P 500 equally (or bought an S&P information technology index ETF) and held on to the entire sector.
Why benchmarks are important
It’s human instinct to compare. So much so, we might not even be aware we’re doing it. A benchmark makes sure you’re comparing apples to apples. But, more importantly, they can also show you if you’re paying too much for your investments.
Benchmarks vs. savings accounts
Many investors make the mistake of comparing their investment returns to the interest earned in their savings account. When all you know are chequings and savings accounts, it’s only natural to compare where you put your money to where you used to put your money.
But with savings accounts paying less than 1% of interest a year, its easy to outperform a savings account (outside of any recession years). Looking at returns through this lens, even high-fee mutual funds could outperform a savings account over 5 years. But that doesn’t mean the returns you’re getting outweigh what you pay for your investments.
Benchmarks vs. fees
Benchmarks let you know if your advisor is working in your best interest and is really worth the amount you’re paying for them. Even a fee that sounds small, like 2% could be the reason why your portfolio is constantly underperforming the benchmark and could cost you a lot in returns over the long term. Next time an advisor tells you they had a 10% return last year before fees. Ask them what it was like after fees? And if it ended up beating their benchmark. The answer they give will let you know if they’re good at investing or if they’re just benefitting from an overall rise in the stock market.
How to choose a benchmark for your portfolio?
If you invest in mutual funds, a benchmark may already be chosen for you. Now that you know how to use one, make sure you compare your performance after fees and see if that mutual fund is really doing its job.
If you invest on your own, you have to determine which benchmark is right for your portfolio. A very basic example benchmark can be made from your equity/fixed income split, benchmarking the S&P500 to the equity portion of your portfolio and the fixed income portion benchmarked to the Barclay’s aggregate bond index. For example if your portfolio is split roughly 60/40 between equity and fixed income, you find the yearly return of the S&P500 index and multiply it by .6. Then you find the yearly return of the Barclay’s aggregate bond index and multiply it by .4. Add the two results together and you get a benchmark that you can compare to your overall return.
S&P500(without dividend reinvestment):
Barclays aggregate bond index:
To calculate the benchmark, multiply the returns by the amount of your portfolio allocated to equities and the amount allocated to bonds (example: 60% equities, 40% bonds):
19.42 x .6 = 11.652%
3.54 x .4 = 1.416%
11.652% + 1.416% = 13.068%
If your portfolio returned more than 13.068% congratulations you beat your benchmark and have outsmarted wall street.
If your portfolio returned less than this amount than you need to take a look at your investing strategy and how to improve it.
To get a more detailed benchmark, you would have to take a more detailed look at your portfolio. For example if 30% of your portfolio is in Canadian stocks, you will want 30% of your benchmark to be the TSX.
That’s all there is to it.
Now when you look at that 10% return you’ll know whether to be proud and pop the champagne, or whether you need to do better next year. Either way, you’ll have the confidence to make the next decision on your portfolio.
If you enjoyed this post, please consider sharing it on Facebook or Twitter!
1The S&P500 return was sourced from SP Indices. The Barclays Aggregate Bond return was sourced from The S&P 500 return was sourced from Morningstar.
The information in this blog is for information purposes only and should not be used or construed as financial or investment advice by any individual. Information obtained from third parties is believed to be reliable, but no representations or warranty, expressed or implied is made by Questrade, Inc., its affiliates or any other person to its accuracy.