Institutional investors worry a lot about how their portfolio performs against a benchmark. As a private client, you’re going to hear a lot about benchmarks if you start talking to consultants and high-end money managers.
Should it matter?
In a word, yes. But also, no.
It matters because you don’t want a manager or advisor who hides their performance statistics. If it’s difficult to see what your return was for the last quarter, or the last year, or since you opened your account, you can be pretty sure that there’s a reason for that. They don’t want it to be easy for you to see how your portfolio has performed. You need to demand transparency on this matter. I am consistently amazed at how many “high-end” wealth managers don’t provide their clients with this basic information.
But performance numbers themselves don’t tell the whole story. If your portfolio is up 15 percent, that sounds pretty darn good! However, if the stock market is up 25 percent over the same period, it sounds less good. But the analysis doesn’t stop there. If your manager earned the 15 percent without taking a lot of risk, then it might actually be a pretty good return versus a much higher-risk 25 percent.
What does that mean? Well, if the market was instead down by 25 percent, but the portfolio created for you would only be down 10 percent in that same period, then you’re probably happy to be in that lower-volatility portfolio, even though it means you don’t fully participate on the upside. Protecting the downside is the key to long-term returns.
As you can see, there’s a lot of complexity and no easy answers here. A lot of “it depends.” Which is not terribly helpful, I know.
And that’s also why benchmarks shouldn’t matter that much to you. What should matter is whether you are able to meet your own personal objectives, not keeping up with other investors.
Shortly after a market crash, I proudly told a client that we had a good year. Our benchmark was down 15 percent, but his portfolio was only down 10 percent. Any financial professional would see that as a pretty good job protecting the downside!
Except the client didn’t. He turned to me after my smug little summary of what a great job we did and said, “Don’t ever tell me that it’s a good year after you lost my money.”
Message delivered.
The game of relative returns—the one that virtually the entire investment industry is organized around—doesn’t matter to you. Nor should it.
It goes both ways. You don’t want to lose money when the market goes down, and that means holding lower-risk investments. But it also means that if the market is in the midst of a high-risk speculative frenzy (like now!), you should be able to ignore the money everyone else is making.
It’s hard to avoid the FOMO, I know. We often find ourselves second-guessing a conservative investment stance when speculation is rampant and it seems like every amateur day trader is making money. But resisting FOMO is critical to your long-term success.
So, what is the appropriate use of benchmarks then?
They’re useful for evaluating a specific manager’s performance. (Make sure you’re using the right benchmark, because managers can often fudge this to make themselves look good.) But benchmarks are also horrible for tracking the success of your overall portfolio, because the market return is irrelevant to measuring progress towards your goals.
If you and your advisor determine at the outset that a 4 percent annual return will allow you to meet your objectives, don’t chase a 10 percent return. You don’t have to! Take it easy and sleep well at night. Your benchmark should be that 4 percent—and don’t worry about the frenzy.
Professionals are subject to FOMO as well, and it’s no joke. Legendary investor Stan Druckenmiller famously lost an estimated $3 billion in six weeks by investing $6 billion at the top of the 2000 technology bubble. In his own words:
I just couldn’t stand it anymore. And I’m watching them make all this money every day. For two days I’m ready to pick up the phone and buy this stuff… I pick up the phone and I buy them. I might have missed the top of the dotcom bubble by an hour.
Druckenmiller acknowledged the stupidity of what he had done and that it was driven purely by greed and FOMO.
I bought $6 billion worth of tech stocks… and in six weeks… I had lost $3 billion in that one play. You asked me what I learned. I didn’t learn anything. I already knew I wasn’t supposed to do that. I was just an emotional basket case and couldn’t help myself.
As you can see, this is ingrained in our human nature. If it’s not easy for Druckenmiller, it’s not going to be easy for any of us. The mindset shift is critical to make, and you need to keep reminding yourself what game you’re playing. I want you to look forward to missing out on this year’s hot stock, or the startup all your friends are invested in, or the cryptocurrency you don’t really understand.
Overcome the FOMO. Stick to the long-term plan. Play your own game.
I collected monthly large cap US stock returns going back to 1926 and decided to play around with the numbers.
Let’s say your portfolio only captured 80 percent of the market upside (that is, if the market is up 10 percent, you are only up 8 percent), but with the benefit of only experiencing 50 percent of the downside (so if the market is down 10 percent, you are only down 5 percent). Over close to a century, you will end up with outperformance of just over 12,000 percent.
OK, that’s a little bit extreme. Let’s dial it back by giving up some upside.
If we capture only 70 percent of the upside, the outperformance over time is 993 percent.
I can live with these numbers.
You don’t have to keep up with the market as long as you can control your downside.
Celebrate your ability to tune out the noise. Don’t follow the crowd. Be a maverick. Set your own benchmark.