What is my Benchmark?

“What is my personal investment performance benchmark?” is probably the question individuals should focus on most when deciding on an investment strategy to follow.  Why is it so important you ask? Well for one, it can help to screen out certain investment strategies. Additionally, it provides concrete evidence as to whether your investments are meeting, exceeding or lagging your investment goals. Given the vast array of investment benchmarks, it is probably best to start with a simple explanation of the different types of benchmarks. Broadly, benchmarks fall into two groups, absolute and relative.

The absolute benchmark is not based on the performance of any other investment or index. The simplest example is a “target return” benchmark, such as a target of X% return per year. While incredibly easy to grasp, it does not provide any constraints to the level of risk or what asset classes to utilize. Similarly easy to grasp is the “absolute return” benchmark. To most individuals, this means producing a return above zero. Within the institutional world, an “absolute return” benchmark typically refers to the return on a medium to longer term risk free instrument; most commonly the 10 year US Treasury bond. The rationale here is that any investor can earn the risk free rate of return if they held the bond to maturity; it therefore represents a target that an active manager should be able to beat.

The most common relative benchmark is the return of the S&P 500 or Dow Jones Industrial Index. While these benchmarks are well known, they represent a 100% equity benchmark which may or may not fit an individual’s risk appetite. These are considered relative benchmarks as the return of the investment portfolio is compared relative to the return of another investment. The relative benchmark is useful as it provides a context in terms of the level of risk required to achieve the portfolio return as compared to the risk and return of the benchmark.

The subject of benchmarking elicits many viewpoints and be can be extraordinarily complex. The topic of benchmarking has over 300 pages of material devoted to it within the Chartered Financial Analyst (CFA) qualification. Obviously this article is only scratching the surface. In subsequent articles we will address how individuals and institutions may differ in their benchmarking strategies and in how you might consider your own personal investment benchmark.