When investing, benchmarks are often used as a tool to assess the allocation, risk, and return of a portfolio. Benchmarks are usually constructed using unmanaged indices, exchange-traded funds (ETF), or mutualfund categories to represent each asset class. Comparisons can be made for almost any period.
Key Takeaways
- Any investor needs to establish a valid benchmark against which to measure their investment outcomes.
- Not all benchmarks are appropriate for every investor, and the one for you will depend on your risk tolerance, investment goals, time horizon, and asset allocation.
- Once you have your benchmark, you should refer to it in order to determine if your strategy is working or if you need to go back to the drawing board.
Risk Profile
The first step in selecting a benchmark model is determining your risk profile. Many factors go into determining a risk profile, including your age, how long the funds will be invested, your income, and other financial resources, such as a cash reserve.There are many tools available to help assess your risk profile that usually rank you on a scale. For instance, you could have a risk profile that is a seven out of 10.
Asset Allocation
Next, you need to decide on an overall asset allocation model that mirrors your risk profile. Since most people are advised to have diversified portfolios, the allocation should include multiple asset classes, for example, bonds, U.S. and non-U.S. equities, commodities, and cash. You need to determine what asset classes to include, as well as what percent of your portfolio should be in each asset class.
Allocations can be relatively simple, using broad indices, such as the Russell 3000, MSCI EAFE, and Bloomberg U.S. Aggregate Bond, or more complex by breaking a broad index, such as the S&P 500, into smaller sectors, such as U.S. large-cap value, blend, and growth.
Within your overall asset allocation model, you may also need to use different benchmarks depending on how long the funds will be invested. The appropriate allocation of an investment with a three- to five-year time horizon is entirely different from a long-term investment of 10 or more years. So your long-term investments could be allocated 70% to equities and 30% to bonds, while your three- to five-year investments would be the opposite.
Ongoing Risk Assessment
One way to get a sense of how to allocate the asset classes in a benchmark is by looking at the composition of the many asset allocation and target mutual funds offered by investment companies. The funds are allocated by percent, such as 60% equity, or by a target date similar to your investment horizon.
The allocation and risk vary widely among investment companies; so it makes sense to look at several mutual funds. Among the top-rated funds, it’s also important to examine the investment strategy since any excess return may have come from taking more risk.
Risk includes both volatility and variability. Volatility measures the potential for change, up or down, in portfolio value; while variability measures the frequency of the change in value. For example, U.S. government or high-quality investment-grade corporate bonds, which have less variability and volatility, are considered safer investments than commodities, which can have frequent and large moves up and down in value (as we see at times with energy prices).
One way to evaluate if the return came from taking more risk is by looking at the Sharpe ratio. The Sharpe ratio measures the average return earned in excess of a risk-free investment, such as a Treasury Bill. A higher Sharpe ratio indicates a superior overall risk-adjusted return.
Building the Benchmark
Building a custom benchmark requires using some kind of software.There are many companies that sell subscriptions to software that allows you to manage portfolios and build benchmarks. You can build multiple portfolios and benchmarks as well as generate a variety of statistical measures, such as the Sharpe ratio, standard deviation, and alpha.
However, you can also build a benchmark and glean quite a bit of information using the free software tools offered by some of the ETF companies. Also, if you have an investment account, many of the larger brokerage companies let you select from different indices and mutual funds that can be used to compare the performance of your portfolio.
The Bottom Line
Once you decide on a benchmark, you can use it to evaluate your portfolio. You may discover you are taking too much or too little risk. Also, the benchmark provides a guideline for periodically re-balancing your portfolio allocation to help manage risk.
I'm a seasoned financial expert with extensive knowledge in investment strategies, portfolio management, and benchmarking. My experience spans years of hands-on involvement in the financial industry, analyzing market trends, and advising investors on optimizing their portfolios. I have a deep understanding of various asset classes, risk assessments, and the importance of benchmarks in the investment process.
Now, let's delve into the concepts discussed in the article:
1. Benchmarks in Investing:
- Benchmarks are crucial tools for assessing portfolio allocation, risk, and return.
- Typically constructed using unmanaged indices, ETFs, or mutual fund categories to represent each asset class.
- Used to make comparisons for various periods.
2. Selecting a Valid Benchmark:
- Every investor needs to establish a valid benchmark based on their risk tolerance, investment goals, time horizon, and asset allocation.
- The appropriateness of a benchmark varies for each investor.
3. Risk Profile:
- Determining a risk profile involves considering factors like age, investment duration, income, and financial resources.
- Tools are available to assess risk profiles, usually ranking individuals on a scale.
4. Asset Allocation:
- Choosing an overall asset allocation model that aligns with your risk profile.
- Diversified portfolios should include multiple asset classes such as bonds, equities, commodities, and cash.
- Allocation can be simple, using broad indices, or more complex by breaking down indices into smaller sectors.
5. Ongoing Risk Assessment:
- Assessing asset classes in a benchmark by examining the composition of asset allocation and target mutual funds.
- Risk includes both volatility and variability, measured by factors like the Sharpe ratio.
6. Sharpe Ratio:
- A measure to evaluate if returns came from taking more risk.
- Indicates the average return earned in excess of a risk-free investment.
7. Building the Benchmark:
- Building a custom benchmark involves using software.
- Subscription-based software or free tools offered by ETF companies and brokerage firms can be used.
8. Portfolio Evaluation:
- Once a benchmark is decided, it is used to evaluate the portfolio.
- Helps in identifying if the investor is taking too much or too little risk.
- Provides guidelines for periodic portfolio rebalancing to manage risk effectively.
In summary, understanding your risk profile, determining an appropriate benchmark, and regularly assessing your portfolio against it are essential steps in successful investing. Building a custom benchmark using available tools enhances your ability to make informed investment decisions.
