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Tuesday, May 30, 2023

Using Benchmarking to Measure Investment Performance

A benchmark is simply a point of reference. Often, we use benchmarks to calculate growth, whether it’s marking a child’s height on a door frame or comparing multiple locations of a restaurant business. 

In investing, benchmarks are a way to see how your portfolio’s movement stacks up to specific areas of the financial market. With this data, you can weigh risk, determine how you want to allocate your assets, and analyze your investments’ performance. We are going to take a closer look at this popular method of measuring portfolio movement.

What is a Benchmark?

A benchmark is a point of reference you can use to compare the performance of your portfolio against. Because indexes are composed of select stocks that best represent the overall movement of a segment of the financial market, they are commonly used as benchmarks. What you choose to compare your portfolio to will depend on the type of investments you hold. 

Since many investors have diversified portfolios, benchmarks aren’t always a one size fits all model. You want to select indices that match your asset classes, so often, you will have to evaluate them in sections depending on the different types. 

For example, if you have mainly large-cap US stocks, the S&P 500 or the Dow Jones Industrial Average would be good benchmark indices, but they don’t include fixed-income assets. If you’ve also invested in bonds, you would want to follow the Bloomberg US Aggregate Bond Index in addition. 

Why Use Benchmarks for Investment Performance Measurement?

Benchmarks give a reliable yardstick with which to measure a portfolio’s ups and downs. You can use this information to evaluate your asset allocation and assess your risk. By measuring and analyzing the volatility of a benchmark compared to your portfolio, you can determine if you have a balance that reflects your risk tolerance. All of this data can be instrumental in helping you to optimize your portfolio to align it with your goals.

Although benchmarks allow you to gain some clarity and insight into your investment strategies, they have limitations. Mainly, they are only an indicator of what has already happened. When you’re strictly looking at the past, it has a tendency to blind investors when it comes to making decisions about the future.

How to Use Benchmarks to Measure Investment Performance

Before you can start crunching numbers, you will need to evaluate a few basic elements. Follow the steps below to start using benchmarks to measure your investment’s performance. 

  • First, you’ll want to choose the portfolio or account you want to benchmark. Do you want to look at a 401k or an entire portfolio with multiple assets?
  • Next, evaluate your asset allocation and categorize them into types such as large-cap US Stocks, small-cap US stocks, bonds, real estate, international stocks, etcetera.
  • Then you want to identify and select the corresponding index for each category of assets. For instance, S&P United States REIT would be an appropriate benchmark for real estate investments, while S&P small cap 600 matches your small cap securities.
  • If you’re behind your benchmark, you can zoom into your portfolio and assess which part is causing you to fall behind and use that information to make beneficial changes.

It’s easy to see how tracking multiple indexes and interpreting the results can get a little chaotic. Building a benchmark for all of your securities often requires additional resources, and many investors use portfolio management software. They typically have tools that will help you when customizing, tracking, and calculating investment performance so you can get a complete overview of the results. 

Best practices for using benchmarks in investment performance measurement

Although benchmarking can be a crucial way to gain insight into your investment strategy, you’ll want to avoid falling victim to a few common mistakes. Many investors gravitate toward the most popular index, the S&P 500, even if it’s not aligned with their asset allocation. Not only do you need to identify the correct benchmark, but you also need to use it correctly. If the whole market is down 20% and your whole portfolio is only down 10%, you should consider that a win. 

Here are a couple of tips for using benchmarking effectively:

  • Always account for any transaction fees and taxes. Be sure you’re subtracting them from any gains or losses to get an accurate result.
  • It can be tempting to check in at the end of a quarter, but take the data with a grain of salt. To get the best idea of an asset’s performance, you should look at the performance over several years. Sometimes a particular company can have an unusual quarter or year, giving you a skewed short-term view.
  • Don’t let the benchmark lead you off course. It’s a great reference point and can be useful in relocating your assets, but attempting to mimic an index too closely can lead to illogical decisions. Ultimately, your portfolio should reflect what your personal goals are.
  • Make sure you trust your sources and that the data you’re referencing is accurate and updated. 

Real-world examples of benchmarking in investment performance measurement

Benchmarking is used successfully in many areas of investing. This case study takes a look at how it has played an integral role in real estate as an asset class. It examines the notion that benchmarking is critical to evaluating strategies against fluctuations in the property markets and has made investing in this non-liquid asset easier than ever.

Does Your Portfolio Measure Up?

Benchmarking can be a crucial component in measuring your portfolio’s performance. By comparing your investments to the market’s movement, you can gain insight that will help you balance your asset allocation, consider volatility and make adjustments when needed.

Be sure to choose the appropriate indices that match your securities and take advantage of portfolio management software to help you keep track of the data. Keep in mind that benchmarking is a reference point, and avoid chasing after the patterns of the market. Your personal goals should be first and foremost in your investment strategy. 

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