Fisher Investments Reviews the Importance of Benchmarking
Constructing a portfolio can be difficult, and we have found that without some kind of guide, choosing your investments from the thousands available today can be a tall order. In our experience, basing your portfolio on a diverse, broad model of the marketcalled a benchmarkcan be a good place to start. In Fisher Investments view, selecting the right benchmark is one of the most vital decisions an investor can make, as it helps to guide portfolio construction and provide a measuring stick for performance.
A benchmark is an index that tracks a certain set of securities. We think it is beneficial to have a bespoke benchmark for each segment of your portfolio. After all, if you own stocks and bonds, a stock benchmark probably wont help with your bond portfolio constructionand it would often be an inaccurate measuring stick for bond performance. Therefore, Fisher Investments thinks it is better to use a stock benchmark for your stock portfolio and a bond benchmark for your bond segment.
Fisher Investments reviews of the myriad market indexes in existence has found useful benchmarks have three qualities:
A long history, with performance tracked over several market cycles. We think investors benefit from referencing their benchmarks performance through both bull markets (extended periods of generally rising equity prices) and bear markets (prolonged, fundamentally driven broad equity market declines of -20% or worse). While Fisher Investments doesnt think past returns indicate future performance, it can give investors a framework for assessing whether their long-term financial goals have a reasonable probability of coming true.
A market-capitalization (market-cap, stock price multiplied by share count) weighted index where each security is weighted according to its share of the indexs total size in value terms. Companies with larger market caps have more influence on the indexs movement. We prefer this construction versus price-weighted indexes (g., Americas Dow Jones Industrial Average or Japans Nikkei 225), in which stocks with the highest prices have the most influence. We dont think equal-weighted indexeswhich have equal weights for all holdingsare very representative either. This is because investors earn cap-weighted returns, making price- or equal-weighted indexes inaccurate measuring tools. Additionally, due to their construction, these indexes could lead investors to load up on smaller companies while downplaying larger ones.
A broad, diverse composition. Fisher Investments thinks an effective benchmark stretches across all areas of the marketg., by geography and economic sectorso investors arent overly concentrated in one market segment, nor missing out on certain areas.
Based on Fisher Investments reviews, we think indexes that have these criteria include the MSCI World for stocks and the ICE BofA European Monetary Union (EMU) Broad Market for bonds.
In our view, benchmarks benefit investors by providing a blueprint for portfolio construction, which helps with diversification. Fisher Investments reviews of market data reveal a huge universe of securities. A benchmark provides a starting point to winnow down this pool of available securities instead of picking randomlywhich is more akin to finding the proverbial needle in a haystack. Your benchmarks weightings can guide your portfolios allocation, as they can inform how much exposure you may want in a given geography or sector, and you can see which securities are in each category. This naturally leads to diversificationnot just avoiding over-concentration in certain sectors, industries and geographic regions, but also to individual companies. If a given sector is just 5% of the global stock market, then placing, say, 15% or 20% of your assets in it likely means overconcentrating there while potentially missing opportunities in other categories. Similarly, if a certain company is only, say, 2% of the MSCI World Indexs market capitalization, a weighting far above this would likely introduce excessive company-specific risk.
Another core purpose of benchmarking, in our view: measuring portfolio performance. When you dont compare your returns against a benchmark, you are reviewing absolute returns. In Fisher Investments view, this has potential drawbacks. For instance, say your portfolio returned 20% one year. This number alone might seem like a great return, but if your benchmark is the MSCI World indexand it returned 35% in the same yearthat discrepancy may raise questions about your portfolios composition. It could illuminate tactical decisions that didnt work out or areas where you are over-concentrated, giving you a chance to course-correct. Similarly, if your portfolio falls -10% in 6 months, that may seem bad. But if your benchmark fell -15% or -20% in this stretch, then your relatively better returns mean something went right. Having the benchmark to compare against may reduce the temptation to make a knee-jerk reaction to your portfolios decline, which could lead to errors and missed returns down the road.
If we had just one word to summarize a benchmarks potential benefits, it would be this: discipline. For portfolio construction, a benchmark gives you discipline via a sort of leashit can help keep your portfolio from straying too far from the broad markets composition, which can help you widen your opportunity set and spread out risks. For performance measurement, a benchmark can help reduce the temptation to chase heat when times are good and run at every sign of trouble, as it can put your personal returns in context. While this doesnt guarantee every decision works out wellas nothing can ever do that Fisher Investments thinks discipline can help investors improve their processes and their likelihood of success in the long run.
This article first appeared on GuruFocus.
