To beat the market or not beat the market, that is the question. And of course what I am referring to here in Shakespearian investor-speak is benchmarking. Are you beating your benchmark?
Quite simply, if you are not beating that benchmark then you are leaving money on the table. It is real and meaningful. If you underperform your benchmark by even 1% per year over a 30 year period the difference could be hundreds of thousands of dollars. The difference could be retirement weeks in a nice clean motor hotel in Florida compared to months on the Italian and French Riviera.
Returns count, and your money deserves to be treated with the utmost respect. Your investment decisions and style should be tailored to create the greatest gains, and the performance should be measured.
Here's what happens if an investor underperforms their benchmark by 1% or 2% or more per year over the decades.
Let's take a 28 year old investor who is hitting her prime investing accumulation stage; she has an initial $10,000 in her portfolio and invests $1000 per month in a portfolio and realizes returns of 6% per year, with inflation-adjusted returns. She invests until age 65. Returns are from the retirement calculator on the investment page at tangerine.ca. The calculator will consider a 2% inflation adjustment; of course inflation may be more or less moving forward.
At age 65 she will have a $1,662,771 portfolio value, as an estimate, with that hypothetical inflation adjustment.
If she manages returns of 5% per year the total would be $1,313,000. At 4% she has $1,044,223. At a 3% annual return she has $836,789. The differences are massive and meaningful. A 1% underperformance creates a difference of $349,771. A 2% underperformance creates a chasm of $618,548. Now if we get into the historical averages of individuals' and their real collective underperformance of the market, then the numbers are truly even more alarming.
The above numbers should not be discounted. We hear many investors state that "I don't care if I underperform the market". That should be restated as ...
I don't care if I am giving up $618,548 in retirement funds that would have been available.
I don't care if I have to work an extra 5 years to hit my retirement date.
If investors frame the consequences in years and dollars, they may just reconsider the flippant dismissal of benchmarking. It is a similar approach to budgeting as presented by the author of The Wealthy Barber, David Chilton. David offers a no-nonsense, common sense approach to personal financial planning. He demonstrates how easy it is to create wealth over time. He suggests that we not just spend money, but frame that spending or splurging in work hours. Is going away for the weekend at a very nice resort simply spending $1,200? Or would the appropriate question be "is the weekend worth 50 hours of time in the office or factory floor"? Is that weekend worth 6 days of work? If you say it certainly is, then you might consider it "splurge worthy". I was thrilled to meet Mr. Chilton at a Money Sense Magazine event, and to pick up a signed copy of his "Return of the Wealthy Barber". By the way, David is the best public speaker I have ever witnessed, by a long shot.
There are real consequences to our spending, saving and investing habits.
Benchmarking is quite simple, but it's not easy to do, emotionally. And I have certainly seen investors struggle with the math or finding the appropriate benchmark; and inputting the appropriate numbers for calculations can also be a struggle. I have also seen many investors not be honest with the results.
What is benchmarking though for starters? Benchmarking simply determines, is your active stock picking or fund picking or ETF picking or combination of the above beating the simple passive market gains that are available. But benchmarking is not exclusive to investing and of course it is a common practice within any meaningful business. Here's a simple definition from Wikipedia ...
And then as it relates to the actionable side of the ledger ...
... organizations evaluate various aspects of their processes in relation to best practice companies' processes, usually within a peer group defined for the purposes of comparison. This then allows organizations to develop plans on how to make improvements or adapt specific best practices, usually with the aim of increasing some aspect of performance. Benchmarking may be a one-off event, but is often treated as a continuous process in which organizations continually seek to improve their practices.
And there's the key phrase "improve their practices". Businesses do everything to improve their practices, investors should consider that drive to increase performance as well.
In the world of investing Pimco does a nice job of defining the role of benchmarking. Here's a link to their investment basics as it relates to benchmarking.
In most cases, investors choose a market index, or combination of indexes, to serve as the portfolio benchmark. An index tracks the performance of a broad asset class, such as all listed stocks, or a narrower slice of the market, such as technology company stocks. Because indexes track returns on a buy-and-hold basis and make no attempt to determine which securities are the most attractive, they represent a "passive" investment approach and can provide a good benchmark against which to compare the performance of a portfolio that is actively managed. Using an index, it is possible to see how much value an active manager adds and from where, or through what investments, that value comes.
When we invest, the benchmark is the collective of the group of investors in that market. As we know, in the U.S. equity investment landscape we have the S&P 500 (NYSEARCA:SPY) that is arguably the most widely known and followed index and benchmark in the world. The S&P 500 is simply 500 of the largest U.S. companies across various major sectors. It is an attempt to represent the total U.S. economy and its successes and prospects. it does a pretty good job of meeting its mandate as we find on the Standard & Poor's site.
The S&P 500® is widely regarded as the best single gauge of large cap U.S. equities. There is over USD 7 trillion benchmarked to the index, with index assets comprising approximately USD 1.9 trillion of this total. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
And here is the current sector breakdown.
If you invest in U.S. large cap companies, this is the index that you want to use as your benchmark. Here are the top 10 holdings as of November 28, 2014. That is a handsome group covering 7 sectors.
And as you may know the S&P 500 is not easy to beat. Beating the market is not something the professionals can accomplish with regularity. But ironically the market is largely priced by those same professionals. Here is a mid-year report (2014) from Standard and Poor's on the professional active fund managers vs. the passive indices.
As we can see, some managers are able to outperform the market in a one year period and that number declines considerably over 3 and 5 years periods. We should consider that this study reflects a time period of a robust bull market. For the large cap funds, 86.94% of active managers were unable to beat their benchmark over 5 years.
So don't feel bad if you do the calculations and find that you (or your funds) are not beating the market, if you are not beating the collective pricing of the market by way of the professionals and retail investors who trade those companies and collectively decide what is fair value on any given day. Just remember that in the end, you can purchase that professionally-priced basket of 500 companies for just 5 basis points (.05%) plus trading costs in an ETF such as the Vanguard (NYSEARCA:VOO).
And to confuse things just slightly, let's consider that the S&P 500 is cap weighted, meaning the largest companies have the most influence on the index returns. When we equal weight those companies that returns are even more impressive.
This from a market watch article, and from Nicholas A. Vardy, Chief Investment Officer at Global Guru Capital.
Let's look at the simplest "alternative index" strategy. Instead of weighting the S&P 500 stocks by market capitalization, take the same 500 stocks and weigh them equally - and rebalance them at the end of each quarter to keep the weightings from getting too far out of whack.
With this approach, the top-10 stocks will account for a mere 2% of the index at the start of each quarter.
As simple as this strategy is, a recent study has confirmed that it has outperformed the traditional market-cap-weighted indexes by 2.10% a year between 1967 and 2010.
Investors and mutual fund managers are not bound by capitalization rules, so perhaps you should be beating the market by 2% per year to attain the equal weighted market gains that are available? Of course the equal weighted S&P 500 is available in an index as (NYSEARCA:RSP) from Guggenheim, launched in 2003. Are you beating the market by 2% per year; that may be the question.
Here is RSP vs. SPY from the RSP inception date, May of 2003. Total return calculations are courtesy of low-risk-investing.com. The y axis represents returns, the x axis represents time period in months.
RSP's total return was 235.3%, outperforming the SPDR S&P 500 ETF's total return of 168.4%. The total return includes stock price appreciation and dividends course RSP carries more volatility than the cap weighted SPY. It is a risk-return proposition.
Here's one way to look at the passive market index; it is priced by the professionals and retail investors who spend tens of thousands of hours poring over millions of pages of research. Those managers evaluate the industry sectors, the competition, they meet with management and study the macro conditions, they look at the company numbers and trends six different ways to Sunday and then decide what they think a company is worth by either buying, holding or selling. The price on that company will be the collective wisdom of hundreds or thousands of teams.
When you try to beat the market, you are not trying to beat the indexer, you're attempting to beat the professional money managers who do this for a living, and who each have some 40-70 hours a week to dedicate to the task and they often have access to many support teams.
The indexer takes this company research and expertise (and pricing) and yet does not pay for that time and energy. OK, that indexer might pay that miniscule .05%. It's not often that you can benefit from professional expertise and not have to pay for it. :)
It should be considered that individuals who hold mutual funds and index investors can certainly effect market pricing (valuations) and individual company pricing with increased redemptions or buying activity. They can force mutual fund managers and index providers to buy en masse or sell en masse.
How to benchmark.
Remember, it's important to measure your holdings and approach against the appropriate benchmark. Large cap vs. large cap, mid cap vs. mid cap, small cap vs. small cap, international vs. international, REIT vs. REIT, dividend growth vs. dividend growth indices.
It's also important to follow and apply the same investment history or schedule. We can't simply look at 5 year or 10 year numbers of the index, we need to input our actual reinvestment(s) into an excel spreadsheet (or do manual calculations) and buy more shares of the index in the same amounts that went into your individual stocks. We must consider reinvestments.
And of course, as close as you can and within reason, match the risk or volatility level of your portfolio to that of the indices or investment approach. As you much as you can, everything should be apples to apples. We should also consider any fees and how they factor into the equation and comparisons.
Be honest with yourself.
Being honest with yourself may be one of the toughest challenges. When we become self-directed investors we largely have the goal of beating the market. There is no other logical reason to become a stock picker than to beat the market, not when that great basket of 500 companies is available for 5 basis points. Just as there is no other reason to pay a mutual fund manager a fee, other than that promise to beat the market. Once again, ensure that you are benchmarking against the appropriate index, the S&P 500 is just one example.
Yes it can be tough to admit defeat, that perhaps stock picking left money on the table, that you did not or could not beat the market. We go into stock picking to win, it is a very aggressive and type A thing to do. Winners do not like to admit that they lost. Under performance should not be rationalized away. It's real money, it's your money, and money is not easy to make or replace. And again the costs of underperformance can be hundreds of thousands of dollars, or it can be measured in the additional years that one may have to work to reach those goals.
If you are beating your benchmark, well congratulations, you are likely to continue to be a stock picker, and logic would suggest that you stay on that path and understand why and how you are beating the market.
For those who are underperforming you may or may not abandon stock selection. The process of benchmarking may uncover the reasons why you are underperforming. You may discover that your companies actually did quite well, but perhaps you had too much allocation to one sector, or not enough sector diversification in general. You may have too much of a home bias if you are comparing returns to a globally diversified portfolio. Benchmarking can help you evaluate your portfolio on many levels, it can uncover some shortcomings and suggest areas of opportunity.
And of course, more than stock selection or investment approach, investor behavior through market corrections is responsible for much of the underperformance of investors vs. the market returns that were available. It is always crucial to assess your emotional risk tolerance level and create a portfolio that matches that risk tolerance level. Ask yourself if you feel that you can comfortably navigate through a 30%, 40%, 50% or 60% portfolio value decline. How much of your paper net worth can you watch evaporate without panicking?
Thanks for reading, and best of the season to you from the Great White North.
Happy investing, be careful out there and always know your risk tolerance level, and again I will ask "Got International holdings?"
Disclosure: The author is long SPY, EWC, EFA, BRK.B, AAPL, ENB, TRP. Dale Roberts is an investment funds associate at Tangerine Investment Funds Limited. The Tangerine Investment Portfolios offer complete, low-fee index-based portfolios to Canadians. Dale's commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process. The views expressed are personal and do not necessarily represent those of Scotiabank.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.