Investors can select from a wide variety of ready made financial benchmarks for their investment portfolios.
An appropriate benchmark should reflect your actual portfolio as closely as possible. An apples to apples comparison.
The chosen benchmark should also be easy to calculate for comparative purposes. If you cannot get access to timely data, even the best of benchmarks will be of little practical value.
Today we shall look at common benchmarks used by many investors.
Positive Nominal Return
Think of this as a zero return benchmark.
The goal is to obtain a positive nominal return for the period. Anything that does not incur a loss during the period is good.
Probably best for low risk individuals who invest primarily in cash equivalents or low risk fixed income assets.
Positive Real Return
Real return reflects the impact of inflation on your performance. Nominal return does not.
To calculate real return you must subtract the inflation rate from the nominal rate of return.
Perhaps you invest $1000. At the end of one year you receive $1100. The nominal return on the investment is $100 or 10%. Not bad against a nominal benchmark return of 0%.
But what if inflation for the year was 15%?
In rough terms, let us say that your $1000 buys a specific basket of goods and services on January 1. That same basket at 15% inflation will cost $1150 on December 31.
Although your 10% nominal return sounds good, with 15% inflation your purchasing power is actually eroded over the course of the year. Your real rate of return is actually -5%.
You would have been better off not investing the money, instead spending the money on goods and services. That is the impact of inflation.
Like nominal positive returns, real returns as a benchmark is probably best for low risk investors whose portfolios are heavy on cash equivalents and fixed income.
Given the potentially debilitating effect of inflation on interest and dividend income, I suggest using real returns for benchmarks over nominal ones.
Risk-Free Rate of Return
A good benchmark in general terms.
The risk-free rate is the return you would earn on an investment with no risk. Assets that are fully backed by federal government guarantees are the closest thing to risk-less, although this may become less true as more governments get into serious debt problems. U.S. Treasury bills is one such risk-free asset.
The advantage of this benchmark is that it reflects your portfolio return if it assumed no risk. But, a diversified portfolio will have some level of risk. And, as we saw with our discussion of the risk-return relationship, the greater the risk assumed, the higher the desired return.
By setting a benchmark for assets with no risk, you can easily see if your riskier portfolio generates extra returns to account for the added risk.
The risk-free rate of return can be used as a benchmark for any portfolio. The lower the risk of the portfolio, the more relevant it will be though.
The higher the portfolio risk, the less relevant. This is because you expect a higher risk portfolio to achieve greater returns over time than a risk-free asset.
But how much greater the return is appropriate?
If the risk-free rate is 4%, should a high risk portfolio be expected to return 10%? 15%? 20%? I have no idea. The higher the portfolio risk, the more it becomes an apples to oranges situation when comparing a higher risk portfolio to the risk-free rate.
That is a problem with using 0% or the risk-free rates as benchmarks.
Arbitrary Nominal or Real Returns
A benchmark of 0%, in either real or nominal terms, may not be an appropriate number.
One reason is that your portfolio should be seeking higher returns than 0% anyway. So a null return might not make any sense (apples to oranges).
A second is that even if you beat the benchmark consistently (say averaging 1% per annum), you may not generate enough wealth over time to retire comfortably.
Because of this, some investors choose arbitrary benchmarks. Either in nominal or real terms.
Often there is some rationale behind the number. 10% is always a nice round number. Maybe equities averaged 12% over the last decade, so that seems like a reasonable target. There are many reasons for arriving at a benchmark. Some make more sense than others.
For example, you intend to invest $12,500 at the start of each year for 25 years and want to amass $1 million. To do so, you need to earn over 8% per annum each year. So that may be a relevant target.
Arbitrary return benchmarks may be suitable for balanced (mix of cash, fixed income, and equities), some fixed income, and equity.
These benchmarks are used by many investors.
They are easy to identify and performance data is plentiful.
These common benchmarks give some good general information.
They may show if your portfolio achieved positive returns in either nominal or real terms?
Or if it outperforms a static number chosen based on personal reasons? Perhaps the risk-free rate. Perhaps a return required to meet specific goals.
But these benchmarks often make apples to apples comparisons difficult. They may not adequately reflect the composition and risk of your own portfolio. And if the informational value is weak, it makes the use of that benchmark less relevant.
While these benchmarks are useful in a general sense, I suggest you look at other options.
We will look at more practical benchmarks next time.