When evaluating the performance of your investment portfolio, it is essential to compare it with relevant benchmark indices. Benchmark indices serve as a standard for measuring the performance of a specific market or asset class. Here's what you should consider when comparing the performance of your portfolio:
Selecting the Right Benchmark
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Asset Allocation: Determine the appropriate benchmark based on your portfolio's asset allocation. If you have a significant portion invested in US equities, you can use broad market indices like the S&P 500 or Dow Jones Industrial Average as benchmarks. For specific sectors or regions, there are dedicated indices such as the MSCI World Index or the FTSE Developed Europe Index.
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Investment Strategy: Align the benchmark with your investment strategy. If you invest primarily in small-cap stocks, you can compare the performance of that portion of your portfolio with indices like the Russell 2000 or the S&P SmallCap 600.
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Geographic Focus: Consider the geographical focus of your investments. If you have exposure to international markets, you can use indices like the MSCI EAFE (Europe, Australasia, and Far East) or MSCI Emerging Markets as benchmarks.
Comparing Performance
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Tracking Error: Evaluate the tracking error, which measures the consistency of your portfolio's returns compared to the benchmark. A low tracking error indicates that your portfolio closely matches the benchmark's performance.
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Relative Performance: Assess the relative performance of your portfolio by comparing its return against the benchmark's return over the same time period. Positive relative performance indicates that your portfolio outperformed the benchmark, while negative relative performance suggests underperformance.
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Consistency: Monitor the consistency of performance over multiple time periods. A manager or portion of your portfolio that consistently underperforms the benchmark over several years may warrant closer scrutiny.
Taking Action
Reviewing Underperformers: If a manager or portion of your portfolio consistently underperforms the corresponding benchmark by a significant margin (usually more than a few percentage points), closely monitor their performance. If the underperformance persists for a prolonged period, it may be prudent to consider replacing the manager or reallocating funds to other strategies.
Rebalancing: If a significant portion of your portfolio consistently outperforms the benchmark, consider rebalancing by taking profits from the outperforming strategy and reallocating funds to the underperforming areas. This helps maintain your desired asset allocation and reduces the risk of being overly concentrated in a single strategy.
Monitoring the performance of your portfolio and individual managers is crucial. Regularly review your investments, assess their alignment with your investment goals, and make adjustments as needed to ensure your portfolio remains on track.
Comparing the performance of your portfolio with relevant benchmark indices provides valuable insights into the effectiveness of your investment strategy. It helps you assess the performance of your investments, identify areas of underperformance or outperformance, and make informed decisions to optimize your portfolio.
Summary
Benchmark indices are used to gauge the performance of an investment portfolio.
In order to evaluate the performance of your portfolio for any given period of time, find the corresponding index for each investment in your portfolio. For example, for US Equities, use the S&P 500 For your Small Cap portion, use the Russell 2000 Index, etc.
You can also compute weighted index blends that correspond to your index allocation (e.g., 40% MSCI / 60% S&P). If your manager or the portion of your portfolio significantly (by more than a couple percent) underperforms the corresponding index, be sure to carefully monitor this manager or portion of your portfolio.
If it happens for two or three years in a row, fire the manager. On the other hand, if a significant portion of your portfolio outperforms the corresponding index, consider taking a large amount of money out of this strategy and moving it to the underperforming strategy to rebalance your portfolio.
Tracking the performance of both your portfolio and individual money managers is your most important responsibility.
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