Benchmarking mistakes to avoid

Your investment portfolio returned 8% last year. Pretty good, right?

Or is it?

The answer is not clear cut. In investing, the phrase “it’s all relative” has important meaning. For any particular investor, 8% may seem quite good—or terribly bad—depending on his or her expectations and goals.

This is where having a benchmark—more specifically, the right benchmark — is of critical importance.

A benchmark is defined as “a standard or point of reference against which things may be compared or assessed.” When it comes to investing and benchmarks, the two big questions to ponder: Are you using the right benchmark, and are you using the benchmark right? These seemingly simple queries can trip up even the most seasoned investors.

Using the right benchmark?

When seeking out a reference point for their portfolio, investors tend to gravitate toward some of the most popular market indexes. Oftentimes, however, that may not be appropriate. Case in point: The S&P 500 Index might be obvious and convenient, but that doesn’t mean it’s aligned with an individual’s objectives, preferences and risk tolerance.

Charting the returns of a diversified U.S. bond portfolio or international equity fund versus the S&P 500 is like comparing apples to oranges. Better choices would be the Bloomberg Barclays Aggregate Bond Index for a U.S. bond portfolio and the MSCI EAFE Index for an international equity portfolio.

But proper benchmarking is even deeper than that. Often, a customized or blended benchmark (rather than a single market index) is required to better reflect an investor’s objectives and inform portfolio composition.

You might begin by considering investments from the broadest perspective (e.g., stocks vs. bonds) and then grow more specific: What assets or asset classes do you want the performance of this portfolio to be measured against? What timeframe is appropriate—the next five years, the next full market cycle or the entire investment horizon?

Ultimately, there are three key reasons to not only select a benchmark for your portfolios, but to be thoughtful about choosing the proper one. A good benchmark should:

1. Provide guidance as to the appropriate amount of risk to be taken in the portfolio.
2. Put returns into context.
3. Offer insight into the value of tactical decisions.

Using the benchmark right?

Our research in the BlackRock Portfolio Solutions group has found that benchmarks are understood to be important, yet are not utilized to their fullest benefit.

While 72% of advisors we surveyed acknowledged that benchmarks are important in client performance reviews, 44% confessed they do not use a benchmark when building client portfolios. Benchmarks, it seems, are more often used to evaluate the performance of a portfolio than to design or make changes to the portfolio.

We believe a portfolio is much more likely to achieve its objective (and deliver fewer surprises and disappointments along the way) if a benchmark is introduced from the portfolio construction phase. This is the only way to ensure your objective is translated into an allocation that may best serve it.

Proper benchmarking plays a critical role throughout the investing journey. In the early stages, the benchmark allows you to contemplate what returns are possible, and what risks may be necessary to achieve them. It provides a reference point and a way to implement tilts (weightings in asset classes that are different from those of the benchmark). Without a benchmark, it is impossible to express biases and preferences in your portfolio.

During the investing journey, the benchmark allows you to evaluate your path and manage how far off course you may want to go while expressing those preferences or selecting securities. Proper benchmarking also provides a means for monitoring progress, giving you the ability to evaluate results, ask critical questions about the portfolio’s behavior, and ensure ongoing alignment with both the return target you’ve assigned to your time horizon and the market’s return patterns.

Ultimately, benchmarking should be among the earliest steps in your investing journey and remain your compass as you venture toward your financial goals.

Patrick Nolan is the Portfolio Strategist within BlackRock’s Portfolio Solutions group. He is a regular contributor to The Blog.