How’s your portfolio doing?
Sounds like an easy question. It’s not. Because the followup question should be: “Compared to what?”
Compared to your coworkers? Probably not the best way to gauge your performance, but a popular one.
Compared to the performance you need to reach your retirement goal? A good question, but what if you could reach your goals more quickly by pursuing a different strategy?
Compared to a benchmark? Now we’re getting somewhere. But what benchmark should you use?
Commonly used benchmarks
The Dow Jones Industrial Average, every evening newscast’s favorite index, is a peculiar beast: it rounds up 30 extra-large companies, chosen mostly arbitrarily, and then weights them in an outdated fashion to come up with the number we are all familiar with.
Few funds or investors actually benchmark their own performance against the Dow. The S&P 500 index, on the other hand, is used as a benchmark all the time. However, the S&P comes in two flavors, and using the wrong one makes it easy to overstate performance.
The S&P 500 price index is the one you hear reported in financial news. It does not include dividends. Since everybody considers dividends part of their return, however, and the S&P 500 is currently yielding just under 2% in dividends, they shouldn’t be ignored.
The S&P 500 Total Return index (i.e., with dividends reinvested) is actually a good benchmark for certain portfolios—those concentrating on large US companies with a blend of value and growth strategies. So always look for the Total Return, or “TR” label.
What is a good benchmark?
A good benchmark should roughly reflect the holdings of a portfolio (or fund). That includes characteristics like company size, country, and asset class risk. An S&P 500 benchmark, then, is a good comparison tool for large-cap domestic funds — or investors whose portfolios are in large-cap U.S.-based companies. It doesn’t make sense, however, to use the S&P 500 as a benchmark for a multi-asset class diversified portfolio, or if all your assets are in a total U.S. fund. (That is why the Vanguard Total Stock Market ETF (VTI) tracks the performance of the CRSP U.S. Total Market Index, made up of 4,000 companies; or nearly every public company in the U.S.)
What about your portfolio?
We’ve written in the past about some of the hurdles active investors face: high costs, high taxes, and little evidence that any stock-picker or market-timer actually demonstrates skill rather than luck.
Here’s another problem with active investing: it’s extremely difficult to tell how you’re doing.
It’s not enough to know that your portfolio is up over a given period. That’s great. But the relevant question is: are you up compared to an appropriate passive benchmark? If not, you’re wasting time pursuing an active strategy when you could just buy some ETFs and take more naps.
But calculating your portfolio’s performance and choosing an appropriate benchmark are both difficult tasks.
To calculate performance, you’ll need to get intimate with Excel (or Google Drive)’s XIRR function, unless all of your holdings are with a broker that calculates your internal rate of return (IRR). Most don’t.
Then, once you have your IRR, you need to know what to compare it to. The S&P 500? Probably not, unless your whole portfolio concentrates on large US companies. You need to compare against a portfolio whose equity and bond components are similar to your own. If you specialize in value stocks, for example, compare against a value fund.
If you don’t trade stocks yourself but buy and hold actively managed funds, benchmarking is a little easier. Go to Morningstar.com, look up each fund, and read about its holdings (you did this before buying the fund, right?). Then compare to an index fund pursuing a similar strategy.
The easy way out is the right way
What if you’re a passive investor, holding only index funds or ETFs and rebalancing them regularly without trying to time the market?
You’re in luck. Index funds are defined by buying up their benchmark index (they’re called index funds, after all!), in the same proportions as the stocks comprising the index. You’re not trying to beat the market; you’re trying to do exactly as well as the market. It might be reassuring to check from time to time, to make sure that your index fund’s trend line is almost precisely equal to its underlying benchmark (minus expenses).
Then you can get back to the important calculations: How close am I to retirement? And is it naptime yet?
Note: Direct comparisons between your portfolio’s performance and equity market indices are not without complications. Your portfolio may not be fully invested, may contain options and other derivative securities, may contain fixed income investments, may include short sales of securities and margin trading, and may not be as diversified as market indices. Indices may be unmanaged, may be market weighted, and unlike your portfolio, indices do not incur fees and expenses. Due to the differences between your portfolio and the performance of equity market indices, no such index is directly comparable to your portfolio.
Matthew Amster-Burton is a freelance writer and financial planner in Seattle.