In part 1 and part 2 of this series we talked about the Dow Jones and S&P 500 indexes. In this final part of the series we will look at what is relevant to your portfolio and talk about what to look at when comparing your portfolio to a benchmark.
Understanding What You Should be Watching
If you want to follow a benchmark that is relevant to your portfolio you will first need to understand the makeup of your particular portfolio. A diversified portfolio may include both US and international securities. Keep digging and you may find that you have large, mid and small size companies. Dig a little further and you will see international companies that are based in both developed and emerging market economies. If you are an aggressive investor you may only hold equities but as you become more conservative you may introduce fixed income and cash into your portfolio.
Each of these asset classes; large, mid and, small capitalization US equities, international developed and emerging market economy equities, fixed income, and cash, all have their own risk and return profile and, therefore, they are all benchmarked to their own indexes.
A benchmark that reflects the behavior of your portfolio would need to be built to mimic your holdings. As an example, if your portfolio has 50% large US stocks and 50% US bonds you may look at a blended index of the S&P 500 (US large stocks) and the US aggregate bond index (representing most traded US bonds). This is a blended index because you are combining existing indexes to create your own blended benchmark.
Calculating the Benchmark Return
When calculating the return of this blended index, you simply find the return of each index for a given time period and then weigh that return to the allocation in the portfolio. For example, if the S&P 500 had a 10% rate of return over a given period and the Aggregate bond index had a 5% return over the same time period, your blended index would have a return of 7.5%.
S&P 500 – 10% return x 50% allocation = 5%
Aggregate Bond Index – 5% return x 50% allocation = 2.5%.
Blended Index – 5% + 2.5% = 7.5%
If your portfolio is half US stocks and half US bonds you would expect your portfolio to be close to the 7.5% rate of return of the blended benchmark. Anything above that and you are outperforming your benchmark and anything below that you are underperforming your benchmark. Withdraws from and contributions to the account, selling and buying securities, and allowing your allocation to drift away from the 50/50 mix, along with other factors, can affect your portfolios performance.
Benchmarking is Only Part of the Story
Benchmarking your portfolio is no doubt a useful exercise, but benchmarking correctly can be a tall order. While it is important to know how your portfolio is performing relative to an expectation, it should not be the sole metric for measuring your success in the market.
When looking at your portfolio return take a step back and remind yourself of why you are invested. What is your risk tolerance? What volatility are you comfortable with? Is income or growth the primary objective? What is my time horizon? Focusing only on return in your portfolio can cause you to lose sight of the primary objectives of your portfolio and could cause you to make mistakes.
Take the time to understand what the benchmarks you are looking at represent and which benchmarks are appropriate for you to measure against. Then take inventory of why you are invested in the first place. These steps will help you decide what is relevant information and what is noise.