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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35397  
Subject: INVESTING BENCHMARKS: A Squib Date: 11/3/2006 4:35 PM
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Each investor can set his goals where he will, because investing is an art, not an engineering discipline, much less a science. Thus, there is no single, right way to do any of it, and the past performance of others is merely a suggested benchmark by which to measure one's own performance. Such benchmarks cannot be held up as absolute standards whose failing implies shame or whose surpassing indicates superiority. It can only be said: “They did X, and I did Y.” But is it also merely human to want to benchmark oneself. So there will always be attempts to apply benchmarks, especially for the purposes of self-promotion. But if effective investment policies are to be created, rather than just financial propaganda, it becomes necessary to identify benchmarks which are both historical, as well as realistic. As trading lore suggests: “Never confuse brains with a bull market.”

Portfolios are typically based on three asset classes: cash, bonds, and stocks and, in various proportions and from the long side only, four strategies: cash-management, diversified bonds, diversified stocks, and focused-stocks. More sophisticated portfolios will use other assets classes, such as commodities, and other strategies, such as SAR (Stop and Reverse). But the three asset classes and the four strategies will describe 90-95% of what most investors do.

5% is a reasonable benchmark for cash-management. 8% is typical of the diversified bond component. 13% describes the performance of a diversified stock component. (Alternatively, 13% could be achieved with a focused bond component, but few investors employ this strategy.) 21% describes a focused stock component. Thus, the performance of a portfolio can be benchmarked by measuring the proportion of the whole that each component represents and then summing and averaging the numbers achieved by each component. E.g., the expected, average performance for a classic “balanced” portfolio would be 10.45%, due to the following breakouts:

Focused stocks: 0% allocation
Diversified stocks: 55%
Focused bonds: 0%
Diversified bonds: 35%
Cash: 10%

As the allocations to each component are varied, so will the expected return of the portfolio vary. On average --i.e., ~70% of the time-- an investor should expect to achieve benchmark performance if he is managing his portfolio in a benchmark manner, which means not doing anything egregiously stupid or egregiously shrewd. About 10% of the time, he will modestly out-perform or under-perform. About 5% of the time, serious out-performance or under-performance could be expected, for which scant credit or blame is deserved. Luck –-both good luck and bad luck-- always plays a role in results obtained, no matter the length of the track record.

Charlie
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