What is the best benchmark to use when investing?

When it comes to investing you are likely to want to understand how your investments are performing against some kind of benchmark.

It is no good investing in a fund or funds if you don’t have something to measure the success or otherwise of that investment against, otherwise you won’t know if it is right for you or not.

There is even evidence to suggest that the benchmark that you measure your investments against has an impact on your behaviour when your investments suffer from the inevitable volatility that comes from investing your money in things like shares.

So which benchmark is best?

Before we get to that it is probably worth briefly summarising why you might even need an investment in the first place.

Let’s use an example of you saving money for your retirement, you might need to invest your money into a fund or funds that provide you access to a range of assets (such as property, shares, corporate bonds etc.).

As a minimum most people will want to save £1 today so that they can spend £1 at a future date, the problem with this is that rise in price of most things mean that your £1 saved today won’t go very far in 5, 10 or 20 years’ time.

So you would typically start investing to at least try and offset the effects of inflation. This will carry risk, and this risk will vary depending on how much of your portfolio is exposed to higher risk investments such as equities, and how much is held in what are considered lower risk corporate or Government bonds.

Historically the more exposure you have to this risk the more volatile your investments will be, or the bumpier your ride will be. How you act in these times of volatility will have a huge impact on the outcome of your investment journey.

I love an analogy and so I would like to use one here.

Imagine you have set off on a journey, you don’t know where you’re going but you know you need to go on this journey. You get in your car, and start driving, you join a motorway and to the right of you is a blue car, to the left a red one.

You decide to judge the success of this journey on how you keep pace with the blue car. You notice that the blue car starts to speed up, to a speed you are not entirely comfortable with, but as you are judging your success based on the blue car you decide to speed up, the red car becomes a speck in the rear view mirror.

You carry on measuring your success against the blue car, who decides to stop for a while to get some coffee at a service station. You don’t need a coffee but you feel it is the right thing to do because the blue car has stopped.

InvestingYou wonder how the red car is doing and whether you should have used that car as your measure of success, but the decision has been made and you can’t change your mind now, you’d look silly!

So you get back in the car and decide to hit the road again, you notice that the blue car has left already and so you put your foot down in an attempt to catch them up, again you are out of your comfort zone but you see it up ahead and so decide to keep going, just as you catch it up, they indicate that they are turning off of the motorway, and head towards Walsall!

You don’t want to go to Walsall, so you are now somewhere you don’t want to be and you have had a bad time getting there. You have had an uncomfortable journey, you have been anxious, you have made rash decisions and you are still not where you want to be.

InvestingYou think back to the red car again and wonder if that would have been a better journey, little did you know that the red car went too slow for you, you would have been equally anxious and impatient and so would have most likely made bad decisions following the red car as well.

So what is the answer?

Understanding your destination and when you want to get there would mean that you could ignore the red car, and ignore the blue car.

If you focussed just on where you wanted to go and when you wanted to get there, you could decide how fast or slow you need to travel, and whether you are happy with this or whether you need to change your destination or arrival time.

Back in the real world choosing a benchmark for your investments should be linked to a goal you are looking to achieve, and not a traditional benchmark such as the FTSE 100 or cash, or the XYZ Purple Underpants Index.

These are great for fund managers whose bonuses may be linked to their performance but they shouldn’t mean an awful lot to you and have nothing to do with your plans.

I am reading a great book at the moment called ‘The Laws of Wealth’ by Dr Daniel Crosby, you can buy your own copy here.

The below in an excerpt from that book discussing the merits of goals-based investing versus benchmarking against an index.

He states “In addition to the intuitive appeal of measuring your own performance against your own needs, it also has a host of psychological benefits that make us better investors. Measuring performance against personal needs rather than an index has been shown to keep us invested during periods of market volatility, enhance savings behavior and help us maintain a long-term focus”.     

He then writes about a study conducted by a company called SEI, who could monitor the behaviour of those who used traditional investment portfolios benchmarked against an index versus those using a goal based approach during the financial crisis of 2008.

He continues;   “As I wrote in Personal Benchmark (co-authored with Brinker Capital founder Chuck Widger), researchers found the following distinctions between the two crowds:

“Of those in a single, traditional investment portfolio:

  • 50% chose to fully liquidate their portfolios or at least their equity portfolios, including many high net worth clients who had no immediate need for cash.
  • 10% made significant changes in their equity allocation, reducing it by 25% or more.

Of those clients in a goal-based investment strategy:

  • 75% made no changes
  • 20% decided to increase the size of their immediate needs pool but left their longer-term assets fully invested.”

“As Melissa Rayer of SEI concluded, the key finding was that “goals-based investors are less likely to panic and make ill-informed changes to their portfolio”

This highlights the merits of following your own path and measuring the success of your investment journey based on your own goals and aspirations, not  the blue car, not the red car nor anyone else’s car!

InvestingIf you wanted to add an additional layer of assistance, you could use a ‘sat nav’ (a financial planner) to help you plan your journey and give you pointers along the way. They can’t help you avoid all the traffic jams or the occasional delay but they can keep you on track to reach your destination.

Without the annoying and patronising voice!

Conclusion

Analogies aside, not everyone needs to be investing their money, but the key to successful investing is understanding why you are investing in the first place. Once you understand why, you can measure the success of that investment against your goals.

Benchmarking against these goals means you can start to ignore all the negative headlines of ‘Billions wiped off the stock market’ because, although your investments are likely to fall when something like this happens, behaving in the appropriate way during these times will increase the likelihood of you achieving these goals.   

Changing your investment because of how the red car or the blue car react to the events of the day is the equivalent of you taking your eyes of the road!

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