Are You a Serious Investor?

by Edward F. McQuarrie

"Hey, how'd you do last year?"
"Oh, ah… pretty good. . . yeah, a couple of my mutual funds were way up."
"So, did you beat your benchmark?"
"Huh?"

Can you answer these questions? Have you sat down and tallied up your portfolio's performance for 1995? And if you have tallied up your gains and losses (Quicken junkies take note), have you set a benchmark for yourself?

Without a benchmark, you may know how much money you made; but you don't know how well you did. And if you can't assess your performance, you can't determine whether you need to make changes to your portfolio.

You're not serious.

Overview of this page

This page discusses why every serious investor should construct a personalized benchmark, explains how to do this, and gives examples of how assessing performance relative to a benchmark can assist in managing your portfolio.

You can jump directly to any of the subsections or tables listed below.

Benchmarks for Total Return | Simple Benchmarks | S&P 500 Benchmark | Reality Check |
Problems with the S&P 500 Benchmark | Key Fact | Developing a Personalized Benchmark |
Computing the 1995 Benchmark | Using Your Benchmark to Manage Your Portfolio | Calculating Your Total Return |
Total Returns, 1991-1995, for large stocks, small stocks, International stocks and Emerging Markets |

Back to McQuarrie Home Page | Back to Free Advice page

Of course, you don't have to be serious about investing to put your kids through college, or to retire comfortably. If you start saving early, you save regularly, you save until it pinches, and you put a big chunk of each month's savings into some kind of stock mutual fund, then you'll probably do just fine -- without devoting any more time to investing than is required to scan your account statements when they arrive.

But if that's your profile you never even started reading this article. If you have got this far, then you're the kind of person who subscribes to Money, or Worth, or Smart Money; you own a dozen or more mutual funds; you may be a regular Quicken user; you trade stock tips with your friends; and so on.

But are you a serious investor? Not unless you've taken the time to choose a benchmark and to measure your personal performance against that benchmark --each year and over time.

Allow me to be frank: if you are actively managing your money--choosing new mutual funds, dropping other funds, shifting money around, calculating your total return, and otherwise styling yourself as a savvy investor, yet, you don't know your benchmark -- well . . . you're not serious -- you're just playing! You are definitely making money for other people -- magazine publishers, mutual fund managers, brokers, etc. But is all that time you spend "managing your money" paying off for you? Well if you don't have a benchmark, how on earth can you tell?

So how'd you do last year?

Benchmarks for Total Return

We'll get into the mechanics of calculating your total return a little later (see Calculating your total return). At this point, it's enough to note that the end result of that calculation will be a single percentage figure -- 22.5%, for example (equivalent to turning $10,000 into $12,250 in a year's time). This is what you compare to your benchmark. If your return is above the benchmark, then you did well -- period. If it's below the benchmark, then you did poorly, regardless of whether your total return is a big number or a small number.

Benchmarks are about discipline -- unblinking, clear-eyed self-assessment.

Simple Benchmarks

A. The Inflation Rate

The simplest benchmark is the annual inflation rate, typically measured as the year over year increase in the consumer price index. In 1995 this was 2.5%. The inflation rate is the minimum benchmark you must match or exceed if you are to preserve capital. A dollar bill you stuffed in your mattress on December 31, 1994 is really only worth 97.5 cents today.

As you probably know, the return on certificates of deposit, treasury bills and money market funds has, over the long term, exceeded the inflation rate by a small amount, on the order of 1% or less. That fact should be sobering: it implies that if you took the first step beyond mattress stuffing, and faithfully put your money into CDs at your local bank for twenty years, then when it's over you would have the sum of money you put aside -- and scarcely anything more. In real terms, you get no significant appreciation at all -- just a few percent more dollars than those you managed to save.

But wait, it's worse: you had to pay taxes on the interest earned on those CD's. Hence, your inflation-adjusted after-tax total return (if historical patterns hold) will be negative. That's right: you will scrimp and save for decades, and you will end up with less money -- real money -- than you put aside.

Now you already know this -- that's why you invest in the stock market by way of 401k plans, IRAs, Keoghs and the like. You have every reason to expect that such stock investments, over long periods, will exceed the inflation rate by a significant margin. Because you are committed to stock market investing, you need a more demanding benchmark than the Consumer Price Index.

B. S&P 500 Index

The standard benchmark known to most stock investors -- which this article will help you move beyond -- is the S&P 500 Index, maintained by Standard & Poors. To simplify, the index comprises 500 stocks of the largest corporations trading on United States stock exchanges. The index is weighted by market capitalization, so that a one-point move in a large capitalization stock has much more impact on the index than a one-point move in the stock of a smaller company.

In 1995 the S&P 500 Index returned 37.53%. That means that if on December 31, 1994 you had placed all of your portfolio into an index mutual fund designed to mimic the S&P 500 (such funds are offered by Vanguard, Fidelity, Schwab and others), and then gone to sleep all year, you would have turned $10,000 into approximately $13,753 (actually a little less; Vanguard's annual expenses, for example, would have set you back $20-30).

As I said earlier, if, instead of going to sleep, you pored over Smart Money, read the Wall Street Journal each morning, strove to own only the best stocks or funds, and only achieved a total return of 22.5% -- then you messed up, and you need to face this fact. You need to diagnose and correct the errors that caused you to under-perform what I shall call a Rip Van Winkle approach to investing (aka a passive indexing strategy).

Now if you have at least developed the habit of comparing your total return to the S&P 500 Index at the end of each year -- and if you have made decisions over time that have brought you closer to meeting or even exceeding this benchmark -- then congratulations! You have come more than halfway to a disciplined style of investing.

Be aware that last year, the majority of mutual funds failed to match the S&P 500 Index; and that over the past five years, and also the last ten years, most mutual funds failed to match the index's total return. And these are professional money managers who work full time at it, and who are generously compensated when they succeed. So if you, through your own efforts, are matching the Rip Van Winkle approach, you're doing better than the majority of the professionals you read about in the financial press.

If you can just match the S&P 500 over the long term, then on historical evidence you will have an annual total return, in real terms, of just over 7%. In more concrete terms, if you do manage to put $10,000 a year into stocks in tax sheltered retirement plans and if you do this each year for 20 years, then at the end of this period you will have $438,652 in terms of today's dollars (since the 7% has already been adjusted for inflation).

Reality Check

My own sense of human psychology tells me that despite the strong arguments for putting all of your money in an index fund and forgetting about Money magazine and the rest, most people (who have read this far) won't do it. I don't do it myself, and I know the arguments for indexing very well. One difficulty is that you probably have your retirement and other assets spread over too many buckets -- your 401k, your spouse's 401k, your IRA, and so on, and you don't have an index fund available in every bucket. You're stuck with an actively invested portfolio, like it or not.

The second problem is that you don't want to terminate your Smart Money subscription. You like reading about investing. It's a contest of wits that gets you charged up. And (admit it now) deep down inside you know you can beat the index if you work at it. You're smarter than most people. Heck, I still believe it myself, even though I know better (having failed most years out of the last 10).

This is why the more time and energy you put into your investments, the more important it is to know your benchmark and to take an unflinching look at your performance against it once a year. Because if the portrait in the preceding paragraph describes you, and you don't ever look at a benchmark. . . well, where I come from, we call that delusional. You act and speak as if you can beat the index, but you've never checked to see whether you do. That's empty bluster, my friend.

So, how well did you do last year. . . and over the last 3 years? If all that poring over Morningstar reports ended up being a "value-subtracting" activity, then you need to face facts. If you under-perform the index by 2 points, year after year, then over the same 20 year period your $10,000 annual investment will grow to only $347,192, rather than the $438,652 return earned by Rip Van Winkle. Not to put too fine a point on it, your arrogance and delusions of grandeur will have cost your family $101,459.

As I said, investing is a serious matter.

Problems with the S&P 500 Benchmark

If you're a sophisticated investor who reserves the right to actively manage some of your money then you can't rest content with the S&P 500 as your sole benchmark. It's too limited to serve as a benchmark with respect to the entire range of investments available to you, with the result that you get misleading feedback in any given year about how well you did. This in turn can produce needless churning and thrashing of your portfolio. Be aware that bad information is just as problematic as no information, hence the wrong benchmark can be as bad as no bench mark.

An alternative benchmark to the S&P 500 is the classic blend of 50% S&P 500, 40% bonds (Vanguard has a bond index fund you can use), and 10% cash. This is a better choice of benchmark for a more conservative investor who has no intention of keeping every penny in the stock market.

Therein lies the rub: what if you are an aggressive investor-or only a little bit conservative? Then the classic blend is inappropriate for you. The point here is that the best benchmarks are customized to your personal situation.

Ask yourself the following questions. The more 'yes' answers, the more important it is to use a broader benchmark than the S&P 500 or the classic blend alone.

• Do you reserve the right to retire outside the United States?
• Do you have a high tolerance for risk?
• Do you reserve the right to shift a portion of your money into new mutual funds that strike your fancy?
• Are you attracted to unusual types of mutual funds -- for instance, funds that seek out companies in bankruptcy organizations, or that invest in the debt obligations of emerging markets?

If you said 'yes' to retiring outside the United States, then you should probably be accumulating a position in international stocks to hedge against the possibility of a further decline in domestic U.S. asset values relative to the rest of the world. This can be substantial over time (as anyone investing yen or marks in the American stock market over the past two decades will ruefully admit).

Similarly, if you are comfortable with a higher level of risk, then some of your portfolio should probably be in small stocks, which have had historically higher levels of volatility and generated a corresponding higher total return over long periods -- 9% vs. the 7% of the large stocks in the S&P 500. In our running example of $10,000 a year invested for twenty years, a portfolio composed totally of small stocks would have produced $557,645, compared to $438,652 for large stocks; (and, of course, delivered some breathtaking declines along the way).

If you're going to invest in new or unusual funds, then your performance is necessarily going to vary relative to the S&P 500 -- you'd be comparing apples to oranges if you chose the S&P 500 as your sole benchmark, because the S&P 500 represents large domestic stocks--period.

A final point: modern portfolio theory teaches that holding diverse asset classes -- large stocks, small stocks, international stocks, and so forth--produces higher risk-adjusted returns. Essentially, the lack of correlation between asset classes has a smoothing effect -- in any given year one asset class may plunge, while another soars. In essence, the riskier assets within the portfolio raise the total rate of return relative to the S&P 500, while the smoothing effect limits your losses (and gains) in a given year.

Key Fact

As a result of following the precepts of portfolio theory, most sophisticated investors should have under-performed the S&P 500 Index last year -- and should not feel bad about it. You did nothing wrong (more on this below).

Developing a Personalized Benchmark

Below is the benchmark I developed to assess my performance. It reflects my particular life situation: I read the Wall Street Journal every day, I have 25-30 years still to go until retirement, I have a high tolerance for risk, and I reserve the right to retire overseas. To create this benchmark, I selected the asset classes I want to own, made an intuitive guess concerning how much of each asset class was appropriate to my situation, and then picked a published index so that I could measure the return on each of these classes.

You would need to adjust the components and the weights to reflect your life situation. An older investor with a shorter time horizon might eliminate the emerging markets component altogether, minimize the international and small stock component, and add cash or bonds to the mix. Conversely, a young immigrant from overseas with an affluent family background, who contemplates returning to the home country at some point, might increase the international, emerging and small stock portions beyond what I set for myself.

Adjusting the weights is basic financial planning covered in many articles. For most people these weights will change over time, with riskier components receiving a lower weight with age. The components will also vary; but the goal is to have at least 3 quite different asset classes.

Computing the Annual Benchmark

In 1995 the S&P 500 had a great year, small stocks a good year, international stocks an ordinary year, and emerging stocks a poor year, as seen in the table below. Applying my weights to the returns yields a personal benchmark return of 27.0%. If I had invested all my assets in the appropriate Vanguard Index funds and gone to sleep, that is what my portfolio's total return would have been (less a few tens of dollars in account fees). By contrast, in 1994 my personalized benchmark's return was only 1.1%-any return above that represented success.

The fact that in earning 27.0% in 1995 I would have under-performed the S&P 500 is no cause for concern. A diversified investor will almost inevitably under or over-perform the S&P 500 in any given year. Over the long term, however, based on historical evidence, a diversified investor who succeeded in matching the benchmark I set for myself would out perform the S&P 500 -- and take less risk, in the sense of year-to-year volatility.

Using Your Benchmark to Reorganize Your Portfolio

Now I could create a portfolio that would mimic my benchmark simply by selecting the appropriate Vanguard funds. I wouldn't have to read the Wall Street Journal, Smart Money, etc., as I now do. I wouldn't have to deal with so much paperwork to track my funds. And I'd be bored -- as would you. Investing, to me, is an exciting and challenging past time. Maybe I can beat the market (by a point or two) while reducing my risk . . .

If you're like me, then, however much of a role indexing plays in your investment strategy, you reserve some role for active decisions -- even if that's just choosing a new mutual fund now and then. To play fair, you have to benchmark the results of this activity. Follow these steps:

1. Choose the components of your benchmark -- in my case, large stocks, small stocks, international stocks and emerging markets stocks.
2. Sort all of your investments so that they fall under one heading (corresponding to a benchmark component) or another. You may choose to have an additional heading for cash or special situations.
3. In Quicken or in a spreadsheet, tally both the amount of each investment you have and its total return. Make subtotals for each of your headings and calculate total return within that heading (i.e., for all of your mutual funds that you consider to be large stock funds).
4. Look at the total returns for each subheading. Take small stocks, for instance. Your total return in this category last year, from picking a variety of mutual funds rather than just buying Vanguard's Small Capitalization Index fund, should have equaled or exceeded 28.44%. If it didn't, then you have one explanation for why the total return on your entire portfolio may have fallen short of your benchmark. If this under-performance persists over a longer period of time, then you have to think about replacing some of these mutual funds.
5. Look at the percent of your portfolio allocated to each asset class. If small stocks receive a 27.5% weighting in my personalized benchmark, then I need to have approximately that same proportion of my portfolio invested in funds in that asset class. When I applied this analysis to my own portfolio, I found that I was under-weighted in small stocks. Hence, when I make my final Keogh contributions on April 15^th I intend to put the bulk into various small stock funds in order to correct that discrepancy. You are unlikely to meet your benchmark return if your assets are not allocated in approximately the same proportion as the component weights.
6. In any year where one asset class has performed unusually well or poorly your allocations will be knocked askew. Some rebalancing may be required, as you prune back an out-performing class and add to a laggard class.

Now, at last, you know where you stand: which decisions worked out for you, and which went awry; why you exceeded your benchmark or what caused you to fall short.

In a word, you are serious about investing.

Calculating Annual Total Return

All I aim to do is get close to the true figure-I leave to-the-decimal-accuracy to those more obsessive than I. Here is a back-of-the-envelope procedure:

1. Note the total value of your portfolio at the end of 1994.
2. Total up all your contributions during 1995. Subtract any withdrawals. The result is your net contribution.
3. Note the total value of your portfolio at the end of 1995.
4. Calculate as follows: ((1995 year end total minus net contribution), divided by 1994 year end total), minus 1.0, equals your total return expressed as a percentage. Numerical example, assuming $147,500 at the end of 1995, $10,000 net contributions, and $100,000 at 1994 year end: (($147,500 - $10,000) / $100,000)-1.0 = 37.5%.
5. Actually, this is cheating a little bit. Some of your contributions were invested in January, and the 11 months appreciation on them inflates your total. Personally I still use the results of step 4, because most of the exhibits in mutual fund reports, plus the twenty year return calculations I gave above, assume a sum of money available at the beginning of each year of the compounding period, with the next increment not coming until the beginning of the following year. Hence, to return to the numerical example in step 4, any return on the $10,000 invested during 1995 can legitimately be considered as counting toward your goal, which is to come anywhere close to those wonderful tables of compound interest found in said mutual fund reports.
6. Nonetheless, for those of you made of sterner stuff, you can alter the formula in step 4 as follows: ((1995 year end total minus net contributions) divided by (1994 year end total plus ½ net contribution)), minus 1.0 = total return as a percentage. In numbers, (($147,500 - $10,000)/($100,000 + $5,000))-1.0 = 30.95%. This benchmarks your performance against a hypothetical investor who steadily applied the $10,000 net contribution to an index fund over the course of the year. It's still not accurate to the decimal place, but will take you quite close.

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