Human beings are animals. Despite our high intelligence, a majority of our thoughts and actions are dictated by hard-wired connections in our brains… processes and “calculations” over which we have little control. Benchmarking ‑ a process by which we compare investments to indexes like the Dow Jones today or the S&P 500 is one of those natural, yet self-sabotaging, tendencies.
We’re all inclined to do it, yet it in no way helps us reach our most important, personal goals. So let’s talk about benchmarking.
Even Warren Buffett isn’t immune. Although the Oracle of Omaha has proven himself a masterful investor over a multi-decade period, Berkshire Hathaway’s (NYSE: BRK.A) “lackluster” returns over the past few years have prompted many to wonder: Has he lost his Midas touch?
Yet, Buffett’s returns are only lackluster IF you compare them to stock market indices, like the S&P 500 or the Dow Jones today.
Shares of Berkshire Hathaway have returned an average of more than 14% annually over the past four years. Those are returns that any reasonable investor should gladly accept.
Still, naysayers of Buffett’s long-term, value-investing approach will show you a chart plotting Berkshire’s returns relative to the Nasdaq 100 Index since March 2009:
Based on the comparison to the Nasdaq 100, they’ll conclude that Buffett is falling behind… failing… not deserving of your hard-earned investment dollars.
In my eyes, that’s a false conclusion. It’s an example of how benchmarking can lead investors to poor, money-losing decisions.
The pitfalls of benchmarking are many, but the two most important to know are these:
- Apples to Oranges. Many times, the comparison of two stocks — or a stock to a market index — doesn’t make sense.
Warren Buffett doesn’t invest much in growth-style technology stocks, so why would a comparison to the Nasdaq 100 Index make sense?
It doesn’t. Yet the comparison is still made.
Even a more thoughtful or logical comparison fails to account for the myriad of unique variables that affect an investment’s performance.
You can compare the performance of Exxon Mobil (NYSE: XOM) — a large-cap constituent of the Dow Jones Industrial Average — to the large-cap-laden Dow Jones itself and still not determine which is better to own moving forward.
All you can do is describe, in historical terms, which did better over the prior X number of days.
But there’s a bigger problem with benchmarking…
2. No Relation to YOUR Financial Goals.
Here’s a riddle for you…
If Stock A averages 12% annual gains, but can drop 40% in bear markets…
And the Dow Jones averages 8% annual gains, but only drops 25% in bear markets…
An investment in which one — Stock A or the Dow Jones — will allow you to retire comfortably?
That’s a trick question that can only provide nonsense answers.
And that’s the trouble with benchmarking.
Although it’s human nature to compare things — to compare ourselves to our peers and our investments to market averages — the process doesn’t help us reach our own, personal financial goals.
Don’t just take my word alone for it…
Consider a key conclusion reached by Dalbar’s 20th Annual Quantitative Analysis of Investor Behavior report. In their own words:
“Investors should not judge their investment success by market index comparisons but instead, they should evaluate their progress towards achieving personal financial goals.”
Dalbar’s study goes on to delve deeply into statistical proof that shows investors have historically underperformed the stock market. It reminds us of the humbling fact that “the average investor cannot be above average.” And it shows how the long-term return of the Dow Jones is nearly double the return achieved by the average mutual fund investor.
For many investors, the process of benchmarking inevitably leads to performance chasing, whereby they invest in stocks, or funds, that have outperformed the market in recent history, while ignoring stocks and funds that have underperformed.
And then, thanks to Murphy’s Law, those historical trends reverse, leaving investors with losses on the new underperformers, and missed opportunities on the new out performers.
Don’t fall victim to this temptation!
Instead, judge your investment portfolio’s performance relative to your personal financial goals. I think you’ll agree that, at the end of the day, that’s what matters the most.
Of course, simply ignoring the natural urge to benchmark your performance will only help you avoid one of the many psychological pitfalls you face as an investor.
Besides, aside from avoiding the pitfall, you also need a proactive, well-defined investment game plan. You need to set realistic goals, like how much money you’ll need saved, by what age, to retire comfortably. And you need an emotions-free system that’s capable of getting you from Point A to Point B.
My aim is to help you with all of this in the months ahead. Stay tuned.