Are you a fast runner? The answer to that question depends on a massive number of factors. Fast relative to what? A group of toddlers? Usain Bolt? Your high school graduating class? Your work colleagues?
And over what distance? 100 metres? A marathon?
Or to put it in a more realistic context, is the person who wins your local Parkrun every week a fast runner? Compared to the rest of the Parkrunners, yes they are. But put them next to Mo Farah at the Olympic 5000 metres and they’re almost certainly an incredibly slow runner.
No, we’ve not gone off the deep end and launched a running shoe, but this concept is just as important for investors as it is for runners.
Are your investments providing a good return? That’s an equally simple question with an equally nuanced answer. In this article, we’re going to demystify it for you.
As we’ve alluded to there, the definition of good depends on what you’re comparing your investments to. We see this so often with new clients, who are often comparing their existing holdings and wondering why one is “doing better than the other”.
The thing to keep in mind with any form of investment portfolio, whether that’s your UK pensions, ISAs or overseas accounts, is that there are almost unlimited combinations of assets and risk. One account might have provided an 8% return and another a 5% return, but the risk level could be far, far different.
The first step you need to take if you want to know if your investments are winners or not, is to make sure you’re comparing like with like.
It’s a common scenario when someone has multiple accounts, and some of them have performed better than others. It can be tempting to simply look at the percentage return on each and conclude that the one with the higher number is the ‘best one.’
In reality, you need to look much closer at the details of each investment to make that call. In simple terms, you can only truly compare the performance between investments if they have the same level of risk. A portfolio with 80% of the funds invested in the stock market and 20% invested in cash should perform far better than a portfolio which has the numbers switched, with 20% invested in the stock market and 80% in cash.
Comparing the two based on performance alone isn’t a fair comparison.
This is especially the case when it comes to pension funds, because different providers have different default investment options. Company A might provide a default ‘balanced’ portfolio with 70% allocated to the stock market, while Company B’s default ‘balanced’ portfolio could have 50% equity.
Long term returns from Company A would be expected to be better, but it likely means it will have more volatility as well. It doesn’t mean that Company B is ‘underperforming,’ but rather that the portfolio is less risky and growth oriented. In fact, it’s part of a wealth manager’s job to tell you which of these is right for you, or even if a combination of the two is the best option.
So that’s fine if you want to compare a couple of different products, but what if you want to compare your portfolio to the investment landscape in general. Well, this is where benchmarks come in.
A benchmark is a real or hypothetical portfolio of assets which represents a market, sector, industry or risk level. There are benchmarks for just about any asset you can imagine, and some of them you probably already know.
The most commonly used include benchmarks like the S&P 500 index, which broadly represents the performance of the US stock market, or the FTSE 100 or FTSE All-Share which offer the same thing in the UK.
But even these aren’t likely to be of much use to investors, as they will usually want to be more diversified than holding only stocks within a single country.
For that, there are a wide range of companies who provide benchmarking services that cover global investment across multiple asset classes and risk levels. Companies like Asset Risk Consultants (ARC), FTSE Rusell, Bloomberg and Morningstar provide benchmarks for multiple risk levels to compare to.
The important thing is finding the right one for you. The main thing here is to find the benchmark that matches the level of risk you’re taking within your portfolio. If you’re a balanced investor, ensure you’re comparing to a balanced benchmark, and so on.
Simply put, our preferred benchmark for our clients is ARC, the most used benchmark for private client (as opposed to institutions) money management in the UK and Channel islands.
But relative benchmarks only tell one part of the story. If the benchmark return for a year is -20% and your portfolio is -10%, are you likely to be happy with that result? You will likely accept it and feel relieved that your investments have ‘outperformed,’ but is that a result you’re likely to put up with year after year after year?
Because in the real world, benchmarks don’t matter. Does beating a benchmark ensure your wealth grows above inflation? No. Does beating a benchmark mean you’ll definitely have made money? No.
A relative benchmark is a tool that can be useful if you’re looking to make sure your portfolio is up to scratch, but even more important is a real return benchmark. This type of benchmark isn’t related to market performance or what anyone else is doing, but is tied to your own personal goals and objectives.
For example, perhaps you’ve used the Rosecut projection tool in our app and you’ve worked out that you need to generate an average return of 7% in order to reach financial freedom. That 7% annual return is what it will take for you to achieve success, and it’s a benchmark that has real meaning for your life.
Don’t take this the wrong way, a benchmark is important. It’s a valuable way to assess how your investments are performing and whether you need to make any changes to your portfolio or financial plan. Or you need a better investment manager. But it’s always important to keep them in perspective, and ensure you’re looking at the broader picture of your strategy.
In summary, here are the steps you should take to ensure you’ve benchmarked your portfolio properly.
Asset your portfolio assets and their suitability for your risk appetite. If you’re an aggressive investor, your portfolio should match that before you compare it to a benchmark.
Decide which benchmark is most relevant to your portfolio. We use ARC when reporting for our clients, as it’s the most well respected private client benchmarking option out there.
Consider a real benchmark as well. This could be a defined level of return or a margin above inflation, depending on your long term objectives. This benchmark is arguably more important than the relative benchmark you select.
Review but don’t ‘over-adjust.’ Investing is a long term game and it’s unreasonable to expect any investment to outperform the benchmark every single year. A positive real return was pretty impossible last year unless you invested with a hedge fund. Some years will be better, some years will be worse, and you should maintain a portfolio for at least five years before reviewing whether major changes need to be made.
If you want to discuss more about how your investment stacks up to the competition or need help in working out the right return benchmark for you, get in touch with Rosecut today.