Every now and then I’ll run across someone comparing the performance of their portfolio against the incorrect benchmark. For example, if your portfolio was only blue-chip Canadian stocks and you surmised that your investing prowess is superior because your portfolio’s returns were better than the S&P 500 over the last decade your reference is almost meaningless. In this case your benchmark should be the S&P/TSX 60 Index.
But what about those who have a portfolio consisting of some US stocks, Canadian stocks, some international stocks and a smattering of domestic bonds? How do you know if your portfolio measures up? In this case you must create your own weighted-average benchmark.
For example let’s assume that our investor has 35% of his stocks in blue-chip Canadian stocks, 25% in a broad selection of US equities, and 40% of his portfolio invested in individual Canadian bonds of various maturities, credit ratings and issuers (Government and Corporate bonds). If his overall portfolio return was 4.2% for the last calendar 3 years, is this good?
Well to create a meaningful benchmark you would need to create a weighted-average benchmark based on the indices out of which he has picked his investments. In this case it might be:
35% x S&P/TSX60 Index + 25% x S&P 500 Index + 40% x DEX Universe Bond Index
Let’s create some data (these are not actual performance figures, I’m making them up) for the last 3 years:
S&P/TSX60 Index 3 Year Average Return: 8.5%
S&P500 Index 3 Year Average Return: 4.5%
DEX Universe Bond Index 3 Year Average Return: 4.5%
In this case the calculation for the weighted average benchmark performance would be:
35% x S&P/TSX60 Index + 25% x S&P 500 Index + 40% x DEX Universe Bond Index
= (35% x 8.5%) + (25% x 4.5%) + (40% x 4.5%)
= 2.975% + 1.125% + 1.80%
= 5.90%
In this case, the investor’s portfolio’s average annual 3 year return of 4.2% has lagged the appropriate benchmark and it might be time to analyze why.
Great entry on benchmarks, Preet.
It’s also important to note that your financial advisor should set both relative and absolute benchmarks with you on your investment policy statement.
A relative benchmark is what Preet is talking about, which tells you the performance of your investment portfolio relative to a market index. On the other hand, an absolute benchmark is set by your financial advisor (or yourself) after evaluating your circumstances, such as your goals for retirement. It is an arbitrary number derived at after taking into account risk and your goals. For example, I need an 8% return from my portfolio each year.
Determining your absolute benchmark beforehand will make your advisor more accountable for the results, while having a gauge of your relative benchmark is an excellent way of assessing your advisor’s (or your) performance. If your advisor hasn’t set relative benchmarks to your investment portfolio, visit http://www.showmethebenchmark.ca….a site set up by one of my virtual mentors, Warren McKenzie, and other fee-only financial advisors.
Zahid Jafry
Onus Consulting Group
http://www.advisormecca.com