by Tim Goodwin
Benchmarking has become a standard practice for investors especially with the proliferation of mutual funds on the market all vying for attention. TV ads and investment newsletters blast benchmark results on a daily basis, creating a herd mindset that they must be important. Also, as the number of indices has grown over the years, investors have more ways to compare their funds; but, can this method of evaluation provide investors with the kind of information that can properly guide their investment choices over the long term?
Why Benchmarking May Not Work
As many studies indicate, mutual investors who turn over their funds frequently rarely achieve returns that beat the market. It is also common knowledge that the vast majority of fund managers fail to consistently beat the major market indices. And, to the chagrin of investors, very few funds that do track or beat the indices in a given year go on to repeat that performance very consistently in subsequent years.
While benchmarking mutual funds is a valid way of evaluating funds, investors may be missing the mark if they rely too heavily on them for making their investment decisions. By focusing on fund performance as compared to the market, investors may become overly sensitive to the market risk they are assuming and make abrupt decisions in an effort to mitigate the risk or chase surging mutual funds.
What’s the Real Target?
If, instead, investors benchmarked their fund performance using their own financial objectives, they wouldn’t be inextricably bound to the relative performance of the markets. Rather, by using a more absolute measure - your own financial objectives - decisions can become clearer and more forthright.
For instance, if, through your planning, you have determined that, in order to reach your retirement objective, your funds need to grow at a rate of 6% per year, how much does it matter what one mutual fund is doing versus another or versus an index, so long as your overall portfolio is achieving a 6% return. Trying to benchmark your mutual funds against irrelevant indices is a distraction at best, but it is more like taking your eye off the ball.
There is absolutely nothing wrong with trying to manage your mutual fund portfolio in an effort to earn the best possible returns, but if your sole objective is to outperform the market each year, you may find more frustration than success. Very few people have ever become extremely wealthy investing in mutual funds; however, millions have used them to help them achieve financial independence.
You’ve done the planning. You’ve defined your objectives. You know where it is you want to go, and the stock market is simply one vehicle to help you get there. By taking a long term approach and selecting funds that most suit your preferences and tolerance for risk for a diversified and well balanced portfolio, you will spend some years underperforming the market and some years outperforming the market, but the only benchmark that really matters is whether you are on track to meeting your own objectives.