Investors spend significant amount of time and effort to select securities for their portfolio. Therefore, it is essential to evaluate periodically how the portfolio performed in terms of not only the return earned, but also the risk experienced by the investor. One of the most common methods of evaluating portfolio performance is comparing the portfolio return with that of the Index returns. Let us discuss some of the common mistakes that are committed by investors while choosing their benchmarks.
Problem with benchmark
A benchmark is defined as ‘a standard or point of reference against which things may be compared or assessed’. When seeking out a reference point for their portfolio, investors tend to gravitate toward some of the most popular market indexes. Investors typically use S&P BSE Sensex or NSE Nifty as the proxy for the market portfolio because it contains a fairly-diversified portfolio of stocks, and the sample is market-value weighted.
The index may be obvious and convenient, but that does not mean it is aligned with an individual investor’s objectives, preferences and risk tolerance. Unfortunately, it does not represent the true composition of the market portfolio. It includes only common stocks and most of them are listed on the BSE or the NSE. Notably, it excludes many other risky assets that theoretically should be considered, such as numerous OTC stocks, bonds, real estate, coins, precious metals, stamps, and antiques.
Why proper benchmarking
Proper benchmarking plays a critical role especially in the early stages as it allows you to contemplate what returns are possible, and what risks may be necessary to achieve them. Further, it provides a reference point. Without a benchmark, it is impossible to express biases and preferences in your portfolio. During the investing journey, the benchmark allows you to evaluate your path and manage how far off the course you may want to go while expressing those preferences or selecting securities.
Accordingly, any useful benchmark should have the following characteristics.
Unambiguous: The names and weights of securities comprising the benchmark are clearly delineated.
Investable: The option is available to forgo active management and simply hold the benchmark.
Measurable: It is possible to calculate the return on the benchmark on a reasonably frequent basis.
Appropriate: The benchmark is consistent with the general investors’ investment style or biases.
Reflective of current investment opinions: Investors’ have current investment knowledge (be it positive, negative, or neutral) of the securities that make up the benchmark. If a benchmark does not possess these properties, it is considered flawed as an effective management tool.
The Indian equity indices were created to be used as benchmarks for the general and overall performance by investors who attempt to outperform the market, not for diversified portfolios. Generally, any stock index has a slightly higher expected return and significantly higher expected volatility (risk) than that of a well-diversified portfolio. Using a stock index as a benchmark for a diversified portfolio is like comparing apples to oranges.
Ultimately, benchmarking should remain your compass as you venture toward your financial goals. Proper benchmarking also provides a means for monitoring progress, giving you the ability to evaluate results, ask critical questions about the portfolio’s behaviour, and ensure ongoing alignment with both the return target you have assigned to your time horizon and the market’s return patterns.
The writer is professor of finance & accounting, IIM Shillong.