5/22/14 – Using Benchmarks to Meet Your Investment Goals

I’m at the J.P. Morgan Research Summit today. Yesterday’s sessions were excellent, and one discussion seemed particularly applicable in light of my recent posts on moving averages.

The session focused on how to benchmark various investment strategies, particularly newer, more complex strategies that don’t have a long track record or a natural benchmark, such as the S&P 500 for stocks.

Why do benchmarks matter?

In short, benchmarks can tell you who is succeeding and who is falling behind. The old saying “you can’t manage what you can’t measure” applies more to investing than almost anything else. Benchmarks give you a meaningful way to judge your progress.

Two ways to use benchmarks

There are two general approaches to benchmarking: using an investment-centric metric or using a client-centric metric. In other words, you can either measure how the investment is doing or how you are doing in pursuit of your goals.

Historically, investors have done the former. Relative measures, such as performance against the S&P 500, are easy to evaluate, provide a clear guide for success, and, not least, are relative. If the market drops 20 percent and you drop only 10 percent, that can be considered a success. This is the measure that works best from an investment manager standpoint.

Which measure is best for investors?

The question is whether this approach makes sense for individual investors. Losing money, even if you outperform the index, typically won’t help you meet your goals. Equally, outperforming the market, with the assumption of a lot more risk, may look good from an investment benchmark standpoint but not as good based on a personal goal benchmark.

This is why I recommend establishing your own benchmarks for your investments, specific to your personal goals.

Here’s an example: A retiree sets up the following benchmarks for his portfolio, based on certain risks and needs:

• Returns of inflation plus 4 percent over the past three years. This benchmark measures whether the retiree’s investments are actually meeting his income needs. Inflation plus 4 percent reflects the usual withdrawal rate of 4 percent, as well as protecting purchasing power. Using a three-year period guards against one-year fluctuations (he might even want to use five years).
• A maximum drawdown of 20 percent during that time period. This benchmark relates to both risk and income. A loss of 50 percent requires a gain of 100 percent to get back to even, so drawdowns need to be managed closely, especially early in retirement. Along the same lines, any drawdown is exacerbated by the retiree’s ongoing need to withdraw funds. For a younger person, of course, this might not be an appropriate benchmark, as there’s a much longer time frame to recover any lost value.
• A maximum return of the S&P 500 minus 5 percent. Finally, this benchmark serves as a risk management tool by limiting returns. Returns are generally matched with risk; if returns are very high, your risk probably is, too. For this retiree, returns that are too high should be almost as troubling as too-low returns.

Note that none of these benchmarks applies to individual products or asset classes; for those, more traditional benchmarks remain appropriate to evaluate manager skill.

For investors, though, special benchmarks tied to your objectives can provide the same kind of guidance, helping you assess your own performance—and meet your goals.