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How to benchmark investments

Benchmarks can offer valuable perspective on the performance of your investments, your portfolio and even your managers. However, as Chris Evers explains in a Money Talk Video, benchmarks need to be used properly or they could give investors the wrong impression. Chris spoke with Joel Dresang. A transcript of their conversation is below.

Joel Dresang: Chris, when we talk about measuring the performance of investments, we mention benchmarks. Explain what those are.

Chris Evers: A benchmark is a tool that investors use to summarize the performance of the overall market, the broad market, and then you can look how you have done compared to that.

Joel: So, give some examples of benchmarks.

Chris: The most common benchmark that’s used is going to be the S&P 500, which you see in the newspaper every day, and that’s going to summarize large-cap U.S. stocks. On the bond side, a lot of times, people use the Barclay’s U.S. aggregate. That’s probably the most common there. And then, when you’re looking at international stocks, the MSCI EAFE is a benchmark that’s commonly used as well.

Joel: So how are these benchmarks used to show us how investments are doing?

Chris: The most typical way to use a benchmark, people will just take the benchmark and compare it with their specific investment – say, their mutual fund – and they’ll say, “How have I returned relative to the benchmark over a time period?”

So, how has my mutual fund over the last three years, maybe five years, returned, compared to say, the S&P 500? And maybe my fund has returned 3% and the S&P has returned 4%. It gives us a little color, a little something to work with, in terms of giving us an idea of our performance.

Joel: And these are also used to help evaluate how your fund manager is performing?

Chris: Yes. We can say, “Well, this is the performance relative to the benchmark,” but also, “Where is this manager finding value? How are they deviating from that benchmark in terms of either sector or specific security allocation?” What we can do is look at mutual fund managers and how they’re allocated relative to the benchmark.

Joel: And you were telling me that there are common mistakes that you see when people use benchmarks. Tell us about those.

Chris: There is a couple pitfalls. With any tool, if you use it wrong, it’s going to hurt you. So I think it’s important that investors not only look at the return relative to the benchmark but also risk and most importantly, that they make sure they use the correct benchmark.

If you’re looking at a large U.S. stock mutual fund, and you’re comparing it to the MSCI EAFE, which is an international stock market benchmark, you can’t really get good data out of that.  It’s not going to tell you the story you want to know.

Also, you need to look at longer time periods. Don’t just look at say, one year or a few months and assume that gives you a good idea of the quality of your portfolio management.

Joel: So we can use benchmarks to look at investments and managers. What about portfolios?

Chris: What we do as advisors sometimes, we’ll actually construct a custom benchmark. So we’ll take, for example, 60% S&P 500 for your stock allocation benchmark, and then we’ll take 40% Barclay’s U.S. aggregate, just for a simple 60/40 stock/bond benchmark. We’ll compare this to your portfolio that’s a 60/40 portfolio.

We can see, well, how has our manager selection done as a whole? Have we selected the right managers in the different categories? And then, when we do deviate from that 60/40 mix in our portfolio, are we adding value by doing that? Are we getting paid the extra return if we take more risk?

Joel: So it sounds like a benchmark is a tool that investors can use at various levels of sophistication.

Chris: At the end of the day, a benchmark’s going to give you the ability to make a decision on your fund management and how you have invested so that you can make better decisions going forward and make sure that you’re investing in a rational and unbiased manner.

Chris Evers is a registered representative and associate at Landaas & Company.

Joel Dresang is vice president-communications at Landaas & Company.

Money Talk Video by Peter May and Jason Scuglik

(initially posted March 31, 2016)

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