Establishing an appropriate benchmark for a portfolio is essential if one is serious about investing. Avoiding portfolio bench-marking is an act of self-deception. Exactly what is the purpose of a benchmark and what are the requirements for a fair and reasonable benchmark. Here is one definition of bench-marking.
In the investing world, the S&P 500 is frequently used as a benchmark for portfolios made up of U.S. Equities. Even though the S&P 500 is a common benchmark, it is not the most appropriate as it does not satisfy all benchmark requirements listed below.
1. The benchmark must be investable. If one is using the S&P 500 as the benchmark, then an investable vehicle is the VFINX index fund as it closely tracks the performance of the S&P 500.
2. The benchmark must be identified in advance. It is unfair to set up a benchmark after the fact so the portfolio shows up better with respect to the benchmark.
3. The benchmark must be objectively constructed. Many investors will use a simple benchmark such as Vanguard’s Total Market Index ETF, VTI, or the index fund, VTSMX. These are certainly objective benchmarks as one can easily understand their construction. It becomes more difficult to meet this requirement when one begins to put together a customized benchmark.
4. A good performance benchmark has an unambiguous composition.
5. A good performance benchmark is easily measured.
6. A strong portfolio tracking tool provides the user with a means for measuring portfolio risk.
Why do investors avoid portfolio bench-marking? 1) It takes time to learn, understand, and implement. Most investors do not have the time or inclination to set up portfolio benchmarks. 2) There are few affordable tools available for the small investor to adequately benchmark their portfolio. Even the affordable commercial programs have gaps when it comes to meeting the above standards. 3) Investors do not want to know the truth about the performance of their portfolio. 4) Investors insist in setting up their own standards of portfolio evaluation, well outside the accepted standards of the industry.
Caution: Whatever you do, avoid the “Beardstown Ladies” portfolio tracking mistake.