I recently heard someone say, “Beat inflation, not the market.” That got me thinking about how important it is to choose benchmarks for judging success that really fit the problem you are trying to solve. This is especially poignant now, since it's December, and many of us are taking stock of our year, looking at our goals and accomplishments, and making plans and adjustments for 2020.
We manage what we measure, adjusting our strategies based on our metrics of success and failure. It’s important, then, to know which measures are truly appropriate and which are red herrings. Looking at your own investment strategy, what is an appropriate measure of success or failure?
Measuring against the market doesn’t make sense
It’s easy to compare your annual returns to the returns of the overall market, mostly because you can find market-return information so easily. Every investment platform and news outlet reports market performance practically up to the minute, so the market’s return would seem to be a very important measure and a good way to judge if your own investments are keeping pace. This assumption doesn’t really hold up well under scrutiny, for a few reasons.
First, research has yet to verify a proven strategy for consistently beating market returns, so chasing that goal has long odds to begin with.
Second, if you have diversified your portfolio, you will not always beat the market, because diversification intentionally lowers your risk exposure, meaning that when the market is way up, you will be somewhat up, but when it is way down you will only be somewhat down. You can’t consistently beat the market in both greater gains and smaller losses (see my first point)--and if you can, and you can prove it, please get in touch, because I’d like to see those numbers. The point here is that long-term investment strategies aim at slower, steadier growth over time, so looking at short-term performance (yes, one year is short-term) doesn’t make sense anyway.
Third, the Sensex is a measure of the stock values of 30 large companies. The BSE 500 consists of 500 stocks. But what do the values of those specific companies have to do with your portfolio? Comparing your investment performance to these benchmarks ultimately answers the wrong question. “Did I beat the index?” has little to do with whether or not you are on track to reach your financial goals.
Better benchmarks
The best benchmark is your own, personalized financial goal. This doesn’t need to be performance-based, either. Having a goal to reduce your unsecured debt is just as worthy as a goal to grow your assets. Improving your credit score and establishing a six-month emergency fund are excellent goals.
When it comes to investment returns, your long-term goals should determine your benchmarks.
- If you are in the accumulation stage
A long-term investment strategy can’t be properly assessed using a short-term metric. If you are in the accumulation phase of your financial life, then the question you want to answer is, “Am I on track to reach my goals on time?” Losing money--even a significant amount--doesn’t necessarily put you off track, since most investment strategies factor volatility into the plan. That means that you need to expect to have years where you lose money.
Whether or not you are on track is determined by your returns over time, not in one-year chunks. So, rather than looking at 2019’s returns to measure the effectiveness of your strategy, look at the average growth of your accounts over the last five years or so. How does that trajectory look? Unfortunately, there is no premade benchmark for this. You have to do the math yourself or ask a financial advisor to do it, which is probably why so many people just use the readily-available-but-completely-inappropriate benchmarks of the Sensex and Nifty.
- If you are in the withdrawal stage
If you have reached your accumulation goal and are now in the withdrawal stage, then the question you need to answer is, “Did I beat inflation?”
If you are withdrawing funds at a reasonable rate, then your principal is likely secure, but your money still needs to outpace inflation. Retiring at 65 on an annuity income of Rs 12 lakh/year may be fine, but when you are 90 that same lifestyle will cost you double. Your assets need to keep pace with inflation or you will have to lower your withdrawal rate as you age, which is not a happy prospect for many.
When market benchmarks DO make sense
The one time when a market measure is actually appropriate is when your investment strategy was specifically designed to track a certain index. For example, if you own an actively managed fund, then it absolutely makes sense to judge its performance against a benchmark, such as the market it invests in. Even so, you will still want to give it more than a one-year stretch before you can truly assess performance.
The bottom line
Overall, the point remains that your strategy should determine the benchmark, and unless your strategy was to track or outpace the Sensex or Nifty, their performance is pretty much irrelevant.
Short-term market performance is a red herring that creates a booby trap for investors.
To truly judge the success of your investment strategy, you need to first be clear about your goal, and then choose a measure of success that suits the strategy for reaching that goal.
This article initially appeared in Morningstar.com and has been edited for an Indian audience
