Thursday, August 4, 2011

Use the Right Benchmark

One of my first posts was about the relationship between risk and reward.  The premise was that if you are going to entice somebody to take a risk, you are going to have to offer them the possibility of a greater reward.  This holds true in all forms of investing.  If you are going to invest in something with risk (like stocks), you are going to demand that you will get a higher return over the long run than if you invested in something risk-free (like a Certificate of Deposit).  This is to compensate you for the additional risk over the short term.  Stated another way, if you earned the same rate of return from a risk-free CD as you would from a risky stock, you would pass on the stock and invest in the CD.  That is common sense.

However, common sense sometimes is uncommon when it comes to determining if your investments are doing "well".  Consider the following statement:

"Last year, the S&P 500 went up by 10%.  However my financial advisor only earned me 8%.  Therefore my financial advisor must be stupid/ignorant/the-second-coming-of-Madoff/etc." 

Is the financial advisor really ripping off our speaker?  After all, he could have earned more by buying an S&P 500 index mutual fund and saved on his adviser's fees, right?

Wrong.  This is an unfair comparison.

The S&P 500 is an index which tracks the stock values of the 500 largest U.S. public corporations.  It is 100% invested in large company stocks (large cap stocks in the investing vernacular).  Therefore, is it fair to compare your investment performance against this benchmark?  It is only fair if your own investment portfolio consists of only stocks from large U.S. corporations. 

Your financial advisor knows, based upon his conversations with you, that your goal is to retire in 10 years.  Since you will be needing to live off of your portfolio within the near future, he probably allocated only 60% of your portfolio to stocks.  The other 40% is invested in less volatile investments (bonds, money market funds, CD's).  Because this 40% is less risky, they returned less than the aforementioned S&P 500.  However, these investments have less risk of losing value, which is an important fact considering that you will need the money in 10 years.  Therefore, it is expected that you would earn less than the S&P 500 in some years.  In other years, the stock market might tank, but your investments won't go down as much because you have that 40% in safer investments.  In other words, you are trading potential upside in some years for less of a downside in others.  Less risk = less return over the long run.

A better comparison would be to compare the large U.S. stock portion of your portfolio with the S&P 500.  Perhaps out of the 60% stock portion of your portfolio, you might have half of that in large U.S. corporate stocks (the rest being in small company stocks, international stocks, etc).  Perhaps that large U.S. stock portion of your portfolio earned 10% this year because your financial advisor was wise enough to invest that part of your portfolio in an S&P 500 index fund.  Smart guy, that advisor of yours!

The lesson here is that you should choose the right benchmark to judge an adviser's performance before you call the S.E.C.

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