A benchmark is a reference point against which you can compare an investment or portfolio. A benchmark is most often used as a comparison point for investment returns and can be viewed as a way to measure whether or not your advisor is adding value. For example, a common benchmark for stock market investing is the S&P 500 Index, a composite of the 500 largest companies in the U.S. stock market. If your stock portfolio exceeded the returns of the S&P 500 Index, as a benchmark, it would be an indicator of excellent performance.
Of course, it is important to choose a good benchmark so that you can make appropriate comparisons. A good benchmark considers risk and is a close match to how your portfolio is invested. For example, if your portfolio is invested 50% in stocks and 50% in bonds it would be inappropriate to only compare the returns to the stock market. A good benchmark for this portfolio would also be one that's allocated 50% to stocks and 50% to bonds. Similarly, if you are taking significant risks, such as in start-up companies, or emerging market companies, it would be inappropriate to use the S&P 500 as a benchmark since it has very different risk characteristics. These types of investments should be compared to similar benchmarks, such as an emerging market index.
It is also important to be consistent with your benchmark. If your advisor frequently changes the benchmark for measuring performance, be wary. Changing benchmarks is an easy way to hide poor performance. At Cedarstone we clearly and consistently display our benchmarks on our quarterly reports so that our clients can have an appropriate comparison point.
If you see wide deviations in returns from your benchmark, it may be an indication that your benchmark is inappropriate. I recently reviewed statements from an advisor who used cash as a benchmark for alternative investments. The alternatives had a 9% return and were compared to cash returns of 1%. While this looks like amazing performance, it is simply a bogus comparison. Alternatives are far riskier than cash and not even close to the same investment.
A good benchmark is a helpful tool in evaluating your portfolio but should be used appropriately. If you have any questions about the benchmarks that we use, or would like us to review your account, please give us a call.