How to Choose the Right Benchmark When Measuring Performance

How to Choose the Right Benchmark When Measuring Performance

The question on every investor’s mind is: How am I doing? We all want to know how our investments are performing. There may also be a competitive desire to “beat the market”. The way to answer the question is with benchmarks.

Benchmarks are simply a standard against which performance is measured. We’re all familiar with benchmark indices, such as the S&P 500 which tracks a group of U.S. large-capitalization stocks. Choosing the right benchmark is important—but it’s not always easy. Most investors own a blend of assets including stocks, bonds, money market funds representing a great variety of attributes, such risk levels, geography, capitalization, etc. Creating a bespoke benchmark that best fits one’s unique basket of investments ensures we’re comparing apples-to- apples vs. apples-to-kumquats, so to speak. Choosing the wrong benchmark leads to something called “benchmark error” which is a false reading of true performance.

Many investors are so focused on their quarterly investment returns they overlook another set of important benchmarks—personal benchmarks. In fact, these are the only ones that really matter.

Some mundane examples of personal benchmarks are debt-to-income ratio, liquidity ratio (e.g. emergency funds), housing ratio and so forth. These benchmarks change depending on our life stage—whether we are mainly accumulating, preserving, or spending assets. Yet, most of us don’t think in terms of ratios. We want to know whether we are making enough to meet our retirement age goal, or for those already retired, to provide a sufficient income to enjoy the lifestyle we’ve worked so hard to achieve. Maybe even add a big trip or invest in a grandchild’s education to our plans?

Ultimately, these are the only benchmarks that really matter, and they vary widely from person-to-person. To know whether your investments are performing the way they should, you need to measure them against your unique benchmarks. That is why investors who chase market returns—or try to match those of their colleagues or friends— outside the context of their own personal goals often feel anxious and disappointed. They may also take on more risk than they need. The expression, ‘if you’ve won the game, stop playing” comes to mind.

A sensible approach is to work with a trusted financial planner to a) identify personal goals (e.g. your custom benchmarks), b) design an investment plan to achieve them, and c) monitor performance against the chosen benchmark. Usually, we have multiple goals with various time-horizons at the same time. For example, we may be saving for retirement while also planning for a big trip or home renovation in the short-term. It’s not always easy to manage competing goals on our own. Working with a financial life strategist is a key step ensuring your goals and your returns match up.

ETF Capital Management

At ETF Capital Management, our mission is to enhance your peace of mind by reducing investment volatility, to help you stay the course in order to achieve your personal long-term return targets. Our vision is to help you achieve the highest possible standard of living, enabling you to realize your best and most fulfilled life.

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