A version of this article originally appeared on WSJ.com.
Most people don’t know how to properly evaluate their financial advisor and overly rely on performance as the sole measurement of success. This is problematic because people tend to evaluate their portfolio over very short time horizons in which random chance plays a large role in outcomes. Similarly, investment performance doesn’t necessarily equate to progress towards your life goals.
A better approach is constructing a portfolio-based benchmark and goals-based benchmark to measure their progress. Using a portfolio-based benchmark will allow you to better understand your investments, while a goals-based benchmark will help you measure your progress to the goals that really matter.
A portfolio-based benchmark is constructed using one or more indexes that are specified in advance, measurable and could be realistically followed by an investor on their own.
For example, the Russell 3000 captures about 98% of the U.S. equity opportunity set and, thus, is a good proxy for stocks that could be reasonably be tracked with a low-cost index fund. Investors with investment exposure beyond the U.S. might prefer using a global benchmark like the MSCI All Country World Index or the FTSE Global All Cap Index.
For the bond market, the Barclays U.S. Aggregate Bond Index is a common option, but some prefer an index with a specific duration, such as Bloomberg Barclays short, intermediate and long-term government indexes.
One of the biggest investor mistakes with portfolio-based benchmarks is that they closely scrutinize underperformance relative to a benchmark because they assume something is wrong, but gloss over outperformance because they take as a sign that everything is working as intended. Instead, investors should rely on the portfolio-based benchmark to enhance their understanding of the investment strategies.
Prior to investing, you should take great care to understand how and why their portfolio is different than the benchmark. A portfolio-based benchmark should also allow you to ask better questions when reviewing your portfolio:
- Why did we deviate from the benchmark?
- Is this type of deviation normal or is something wrong with the strategy?
- Are we taking too much risk to earn these returns?
- How do fees impact the performance being reported?
- Is there a cheaper way to access these exposures?
While a portfolio-based benchmark helps you better understand your investments, a goals-based benchmark focuses on your progress toward meeting your life goals. This requires having a clearly defined set of goals, such as paying off a mortgage, funding children’s education or maintaining your lifestyle through retirement.
By using a Monte Carlo analysis that runs thousands of scenarios, you can generate a probability that your financial plan will be successful. By setting a target probability for success you establish a goals-based benchmark and create a more meaningful framework for evaluating market movements as they relate to your personal situation.
When markets begin to fall, people tend to look at their portfolio before anything else. However, reviewing the underlying assumptions of your financial plan would be a better course of action because a thoughtfully crafted financial plan takes those periods of bad performance into account, and does so without emotion.
The goals-based benchmark allows you to ask questions about your portfolio in the larger context of your life goals. How does this recent market movement impact my goals? Am I still on track? If not, what should I be doing differently with my savings, taxes and investment costs?
To hear additional commentary, check out the podcast I did with The Wall Street Journal below.