Investors can review their investment portfolios against a wide variety of ready made financial benchmarks.
Appropriate portfolio benchmarks should reflect the actual portfolio as closely as possible. An apples to apples comparison.
The selected benchmark should also be easy to calculate for comparative purposes. If you cannot get access to timely data, even the best of benchmarks will be of little practical value.
What are a few simple benchmarks, commonly used by investors?
Positive Nominal Return
Think of this as a zero return benchmark.
The goal is to obtain a positive nominal return for the period. Simple, very easy to track.
Probably best for low risk individuals who invest primarily in cash equivalents or low risk fixed income assets. But, as we shall see below, not that great a benchmark in the real world.
Positive Real Return
Real return reflects the impact of inflation on your performance. Nominal return does not.
To calculate real return you must subtract the inflation rate from the nominal rate of return. Inflation data is easily attainable, so this is a simple calculation to monitor.
Perhaps you invest $1000. At the end of one year you receive $1100. The nominal return on the investment is $100 or 10%. Not bad against a nominal benchmark return of 0%.
But what if inflation for the year was 15%?
In rough terms, let us say that your $1000 buys a specific basket of goods and services on January 1. That same basket at 15% inflation will cost $1150 on December 31.
Although your 10% nominal return sounds good, with 15% inflation your purchasing power eroded over the course of the year. Your real rate of return is actually -5%.
You would have been better off not investing the money, instead spending the money on goods and services. That is the impact of inflation. For a real world example, look at Venezuela. How much return would you require to keep pace with inflation? 100,000%? 1,000,000%? 10,000,000%?
A positive real returns benchmark is probably best for low risk investors whose portfolios are heavy on cash equivalents and fixed income. Given the potentially debilitating effect of inflation on interest and dividend income, I suggest using real returns for benchmarks over nominal ones.
Note that a problem with inflation is that official rates may not always parallel an individual’s own cost of living changes. Inflation is usually calculated based on a basket of goods and services. If your own expenses differ in any significance, official inflation may differ from your personal experience. Similarly, official inflation for (say) Canada may not be identical to someone living in Cape Breton, Vancouver, or Yellowknife. Keep that in mind if choosing inflation as your benchmark.
Risk-Free Rate of Return
A good benchmark in general terms. And very easy to determine.
The risk-free rate is the return you would earn on an investment with no risk. Assets that are fully backed by federal government guarantees are the closest thing to risk-less, although this becomes less true as governments get into serious debt problems. U.S. Treasury Bills is one such risk-free asset. Venezuelan debt, likely not.
The advantage of this benchmark is that it reflects your portfolio return if it carried no risk. For example, 100% invested in Treasury Bills. But a diversified portfolio has some level of risk. In the risk-return relationship, the greater the risk assumed, the higher the demanded return by investors. As well, within a specific asset class, risk can vary significantly.
Unless you are 100% in risk-free assets, you should expect greater returns from your portfolio. By setting a benchmark for assets with no risk, you can easily see if your riskier portfolio generates extra returns to account for the higher risk.
The risk-free rate of return can be used as a benchmark for any portfolio. The lower the risk of the portfolio, the more relevant it will be though.
The higher the portfolio risk, the less relevant. This is because you expect a higher risk portfolio to achieve greater returns over time than a risk-free asset.
But how much greater the return is appropriate? That is the tricky question.
If the risk-free rate is 4%, should a high risk portfolio be expected to return 10%? 15%? 20%? I have no idea. The higher the portfolio risk, the more it becomes an apples to oranges situation when comparing a higher risk portfolio to the risk-free rate.
That is a problem with using 0% or the risk-free rates as benchmarks. In assuming some portfolio risk, you expect commensurate returns. However, what that higher level is depends on a few factors. Your risk tolerance, possible returns from other assets, opportunity costs, portfolio fees and expenses, tax rates on different gains, etc. The “commensurate” level will differ between individuals, as well as within a person as their circumstances change.
Arbitrary Nominal or Real Returns
A benchmark of 0%, in either real or nominal terms, may not be an appropriate number.
One reason is that your portfolio should be seeking higher returns than 0% anyway. So a null return might not make any sense (apples to oranges).
A second is that even if you beat the benchmark consistently (say averaging 1% per annum), you may not generate enough wealth over time to retire comfortably.
Because of this, some investors choose arbitrary benchmarks. Either in nominal or real terms.
Often there is some rationale behind the number. 10% is always a nice round number. Maybe equities averaged 12% over the last decade, so that seems like a reasonable target. There are many reasons for arriving at a benchmark. Some make more sense than others.
For example, you intend to invest $12,500 at the start of each year for 25 years and want to amass $1 million. To do so, you need to earn over 8% per annum each year. So that may be a relevant return target.
Or perhaps you rely on historic data or future forecasts. Over the last 40 years, Canadian equities have returned approximately 8.5% annually. However, many financial professionals forecast around 6.0% per annum in the near future. If you decide your Canadian equity benchmark should be a 15% return, you may be making an error. And very disappointed if your actual return does 10%, even though it will be higher than both historic and forecast returns.
Arbitrary return benchmarks may be suitable for balanced (mix of cash, fixed income, and equities), some fixed income, and equity. The challenge is in choosing a return figure that makes sense.
Summary
These benchmarks are used by many investors.
They are easy to identify and performance data is plentiful. Very important when choosing a benchmark. The best benchmarks in the world become meaningless if you cannot get the data.
These common benchmarks give some good general information.
They may show if your portfolio achieved positive returns in either nominal or real terms.
Or if it outperforms a static number chosen based on personal reasons. Perhaps the risk-free rate. Perhaps a return required to meet specific goals.
But these benchmarks often make apples to apples comparisons difficult. They may not adequately reflect the composition and risk of your own portfolio. And if the informational value is weak, it makes the use of that benchmark less relevant.
While these benchmarks are useful in a general sense, I suggest you consider other options.
We will look at more practical benchmarks next time.
