What is an Investment Performance Benchmark?

A Benchmark is a performance goal. Your advisor is paid to produce results that beat the performance of your benchmark. If your advisor does not beat the performance of your benchmark you might as well invest in the index funds that make up the benchmark and reduce your fees by 75%.

Let’s say the investment performance of your stock portfolio was a positive 10% for the past 12 months. You think, “not bad, a double-digit rate of return”. However, what if the stock market is up 20%? Instead of being up 10% you have lagged the market by 10% – a complete reversal.

When your financial advisor says the stock market is up 20% he is usually referring to an index fund that is supposed to represent the performance of the market. Two frequent examples are the Standards & Poor 500 (S&P 500) and the Dow Jones Industrial Average (DJIA). 

Both indices, that are 100% invested in the stock market, act as benchmarks because they are highly visible representations of 500 (S&P) and 30 (DJIA) stocks. But, they are limited because they are invested in one asset class – in these cases, large capitalization U.S. stocks. If your assets are invested in stocks and bonds, these indices do not work as Benchmarks because they only represent the performance of part of your portfolio.

The Benchmark must fairly represent your actual investments. For example, you do not hold your advisor accountable for beating the S&P 500 (a stock index fund) if 50% of your assets are invested in the bond market. You need an investment performance Benchmark that is based on the results of the stock and bond markets.

Asset allocation is also an issue when you build your benchmark. You should use a static, neutral allocation that reflects your tolerance for risk. For example, aggressive investors might invest 100% of their assets in the stock market. Moderate risk investors might be comfortable with a 50% commitment to the stock market. And, a very conservative investor may have a zero allocation to stocks. Why static allocation? You do not change the index funds or the allocations to the funds that represent the performance of various asset classes. Your advisor is responsible for executing an active strategy that is supposed to beat the performance of this passive strategy. Otherwise, why are you paying all of those fees?

You should replace your current advisor if he cannot beat the performance of your benchmark, net of all expenses.