Benchmarks and measuring performance

In simple terms

To know whether a portfolio is doing well, you need two things: a fair benchmark to compare it with, and the right measure of return. Getting either wrong can make good results look bad or bad results look good.

Choosing a fair benchmark

A benchmark should match what the portfolio actually holds:

• An equity portfolio of large companies: a broad large-company index.
• A mix of equity and fixed income: a blend of an equity index and a bond index in the same proportions, for example 60:40.
• A small-company fund: a small-company index, not a large-company one.

Always use total-return versions of indices, which include reinvested dividends; price-only indices understate what the market delivered, as the active and passive funds lesson explains.

Beating an unsuitable benchmark proves nothing. A portfolio full of small, risky companies beating a large-company index in a rising year may simply reflect taking more risk.

Two ways to measure return

Time-weighted return measures how the investments performed, regardless of when money was added or withdrawn. It is the right measure for judging a fund manager, who does not control when investors put money in. Fund factsheets report it.

Money-weighted return measures what the investor actually earned, given the timing and size of their contributions and withdrawals. It is usually calculated as XIRR, the yearly rate that makes the value of all the investor's cash flows add up. It is the right measure for judging your own experience.

Mutual fund statements and many apps show XIRR for your holdings. Compare it with what the same cash flows would have earned in a benchmark index fund to see whether your choices, including timing, helped.

Returns and risk

A higher return is not automatically better if it came from much more risk. Simple ways to allow for risk:

• Compare volatility and drawdowns alongside returns, as the volatility lesson explains.
• Risk-adjusted ratios, such as the Sharpe ratio, which divides return above a risk-free rate by volatility. A higher ratio means more return per unit of volatility.

These measures are useful for comparing similar portfolios, but they rest on past volatility and can be gamed.

Periods: one year proves nothing

Short-term results are dominated by luck and market conditions. A strategy that beat its benchmark in one year may have done so by chance, or by taking risks that paid off that year. Judge over long periods that include rising and falling markets, ideally a full cycle. The decisions and outcomes lesson discusses why outcomes over short periods are poor evidence of decision quality.

Why it matters

Investors often judge themselves and their funds against the wrong benchmark, over too short a period, using the wrong return measure. That leads to switching funds after bad years, chasing past winners, and misreading their own results. Measuring properly gives an honest picture of whether a plan is working.

Limitations

No benchmark is perfect, and blended benchmarks involve choices. XIRR depends on accurate cash-flow records. Risk-adjusted ratios use past volatility, which may not reflect future risk, and they ignore drawdowns and tail risks.

Common mistakes

• Comparing with a price-only or mismatched index.
• Using a fund's return to judge your own experience, or your XIRR to judge the fund.
• Ignoring risk when comparing returns.
• Judging on one or two years.

Try it yourself

1. Write down your portfolio's allocation and choose a blended benchmark that matches it.
2. Find your portfolio's XIRR from your statements or app.
3. Calculate what the same cash flows would have earned in a benchmark index fund.
4. Compare the two over the longest period you have, and note the drawdowns of each.