Remember, The Real Benchmark Is You

This Morningstar‡ report was first published on January 27, 2022.

When you make an investment you are making a short-term sacrifice for long-term gains.

But when you look back, how can you tell if you really won? The mere fact of having achieved a positive performance is not enough (although it is a start). In finance, you have to remember everything is relative: if I earned 7 per cent when my reference market did +10 per cent, I should not be entirely satisfied.

In most cases, investors spend their time reviewing returns against a designated benchmark. But this can lead to a biased comparison, where the wrong things are compared in a wrong time period.

Let's imagine a scenario in which you gained seven per cent in a given period of time. Was it a success? Maybe. What if we throw in the idea that the return was four per cent below the previous year, three per cent above average of portfolios of the same type, two per cent above inflation and one per cent below the desired level of return? Should we consider that a success?

Add to that the fact that, hypothetically, only one asset among all those in the portfolio is attributable to the total return. Then imagine your portfolio took more risk than expected by increasing short-term volatility at certain times of the year. Is it still a success? It's hard to say.

A Complex Territory

This example helps to illustrate the complexity of appropriate benchmarking. There are many variables, some of which you can control: the risk you take, the resources you hold, and the time frame. Others, however, cannot be controlled.

“As individuals, it is important that we can each measure our own success in a way that is appropriate to the circumstances, says Dan Kemp, global chief investment officer at Morningstar Investment Management (MIM).

“Ideally, this will include a robust and repeatable framework, which may or may not use benchmarking tools. The list at your disposal is theoretically endless, although they must be appropriate."

The Ideal Benchmark

In 2012 a study published by the State Street Center for Applied Research, titled The Influential Investor: How Investor Behavior is Redefining Performance, sought to define the forces that would change the financial services industry.

The report pointed out that, while relative performance as measured by classic benchmarks serves the management company, investors' views are more complex and reflect their personal blend of alpha seeking, beta generation, downside protection and asset management.

In this context, the study showed that, for investors, portfolio performance is the main tool by which they judge their asset manager, but it can also be a weakness.

Simply put, the same return has different effects on different investors.

Let's try an example: Mrs. Sandy is 60 years old, has an income of $2,000 per month, has three children and has not yet finished paying off her mortgage. Mr. Keylock, on the other hand, is 40 years old, has an income of $3,000 per month, has no children and inherited his house, so he is not paying back any debt.

The two have invested in the same fund, which has been losing five per cent since the beginning of the year. This result will have very different effects on Mrs. Sandy and Mr. Keylock's personal balance sheets, and is clearly heavier for the former. Same absolute performance, different relative performance.

Check Yourself

The best benchmark is one that looks to the future while remaining aligned with identified financial objectives. In a perfect world, every investor would have their own tailor-made scoreboard to measure the success of their investments, with transparency and perspective.

The challenge is that forward-looking valuation is incredibly difficult to quantify, and there is no one-size-fits-all approach. Classic benchmarking tools (peer relative, index relative, absolute return, real return) are useful, but limited. What matters to investors is whether they can expect their investments to help them achieve long-term gains in the future.

“This mismatch requires care and highlights an important point around process versus outcome," explains Kemp.

“Specifically, it is entirely possible to have a strong process or a good decision with a bad outcome, just as it is possible to have a poor process with a strong outcome. However, more often than not, a strong process will prevail and result in strong outcomes and vice versa.

"This is a key reason why we stress that people should make comparisons over a longer time horizon: it allows the strength of the process – and the combination of many decisions – to unveil themselves."

To give a concrete boost to this concept, MIM analysts have produced a checklist to reinforce the link between objectives and investments, which can be used as a starting point to build a method of assessing your financial performance.

Checklist: Aligning Your Framework to Your Ambitions

• Is there a clearly-defined financial goal your portfolio can map to?
• Are you appraising your investment results over a suitable time horizon?
• If you're using a benchmark, is it realistic and investible?
• Do you need to account for inflation?
• Have you accounted for risk taken?
• Does your portfolio stand up strongly in a forward-looking context?

Checklist: Avoiding Emotional Bias

• Can you avoid recency bias, where you focus too much on the recent past?
• Are you aware of your own loss aversion, and you avoid selling in a panic?
• Can you avoid overconfidence bias, and avoid assuming you were the key factor in your success?

All things considered, appropriate benchmarking is a powerful tool, both analytically and behaviourally.

“Done correctly, it can help investors stay on course and focus on the right things, but done incorrectly, it can have significant consequences," Kemp concludes.