You should compare your portfolio’s performance against predetermined target benchmarks.
We have already covered a few useful benchmarks.
Arbitrary returns, such as nil, the risk-free rate, or a required rate of return based on your needs.
Relevant publicly available indices that reflect the composition and risk of your actual portfolio. This is especially useful when passively investing in index funds. But there are still a few things to watch out for.
Benchmark performance, fees, and expenses against fund peers and category averages.
Better yet, combine some or all of the above benchmark options.
There is one other important benchmark that we have not yet covered.
Comparing your actual portfolio against your target asset allocation.
Target Asset Allocation
Your Investor Profile drives your target asset allocation.
It should factor in your personal circumstances, financial status, investment objectives, personal constraints, risk tolerance, and so on. As such, your target asset allocation will be unique to your own situation.
As your personal situation changes over time, your target allocation will shift as well. But changes should be made only when material events occur in your life (e.g., marriage, children, inheritance, career change) or when you move through phases of your life cycle. Alterations to one’s target asset allocation should not be an annual activity for most investors.
Actual Versus Target
Some experienced investors may compare the expected returns of their target asset allocation to the actual results. This can be done if you can assign expected returns to each asset class. Many investment companies, research firms, and professional organizations publish forecasts for major asset classes. However, these are far from guaranteed to occur.
Instead, compare your actual asset allocation against your intended allocation. It will not likely be the same.
The reason is that your portfolio will probably earn some income in the form of dividends or interest. You may also buy or sell investments from existing liquid assets. These will all impact your cash component.
As well, you will incur unrealized gains or losses on your investments. These changes will affect your actual allocation.
For example, you invest $10,000 on January 1. Your target asset allocation is 70% global equities and 30% in global bonds. You buy 100 shares of Vanguard Total World Stock Index ETF (VT) at $70 per share and 40 shares of Vanguard Total World Bond ETF (BNDW) at $75 per unit. At year end, you review your portfolio and find that the VT shares are worth $90 each and the BNDW shares at $65.
Based on changes in market prices, your portfolio is now valued at $11,600, ignoring any fund distributions. Although you did not buy or sell any shares or units during the year, your portfolio allocation now sits at 78% equities and 22% bonds. Suddenly, you are out of alignment with your planned allocation.
Good or Bad?
When comparing your actual portfolio performance against an index, peer, or arbitrary value, the higher the better.
But in comparing your portfolio against the target allocation, the less variance the better.
Ideally, you would like your actual portfolio to maintain its target ratio as long as possible. But this is not realistic. In creating a well-diversified target allocation, you may have 4-8 different asset classes and subclasses included. As the investments grow in number, it is pretty certain that your actual allocation will differ from the target yearly.
Also, because a well-diversified portfolio should see some assets increasing in value and others falling as they act as hedges against each other’s movements. That is a purpose of being well-diversified.
So your objective in this analysis is to monitor your portfolio and make sure that it stays within a certain range of your target asset allocation.
Target Range
Range?
Yes, range.
To the extent practical, you want to maintain a buy and hold investment strategy. But if you want to ensure a fixed ratio of 70% stocks and 30% bonds, then you will need to rebalance constantly.
In our example above, that might mean selling shares of VT and purchasing additional units of BNDW with the proceeds to rebalance. That works for now. But what about the next review? What if stocks have fallen in price and bonds have increased? You might find that your VT shares are only worth 50% of your total capital. Then you need to sell some BNDW and buy some more VT. And the next review, things may change again.
Not a formula for successful investing.
Instead, use ranges for your target allocations. Maybe you desire a 70-30 split between stocks and bonds. Fine, but create a comfort zone to prevent frequent adjustments. Especially for price changes due simply to normal asset volatility. Perhaps your target range can be 65-75% stocks and 25-35% bonds. Or 60-80% stocks and 20-40% bonds. Though this latter example may be a tad too wide.
That will give you some leeway during your reviews, thereby preventing continuous adjustments with the attendant transaction fees and taxes on capital gains.
The range you select should reflect your individual tastes. Your investor profile, personal risk tolerance, and ongoing review experience will play a large part in how wide the ranges are.
It should also reflect the volatility of the underlying investments. A blue chip equity fund should be less volatile than a small cap software fund. If you want 20% of your assets allocated to each fund, perhaps your target range for the blue chip is 15-25%, whereas the more volatile small cap could be 10-30%.
