Recently, I have been asking myself if it is worth benchmarking the performance of my portfolio on a monthly or quarterly basis.
This is an exciting topic because there are several different views on the subject (I'm assuming all readers of this article are independent value investors and not just S&P 500 index fund holders).
For example, the vast majority of hedge funds and mutual funds benchmark their performance against a set index. Whether they should or not is up for debate. This kind of performance assessment encourages investors to adopt a short-term mentality. If the fund is underperforming over a year or two, then it inspires investors to sell even though performance might be better over the longer term. In addition, relative performance benchmarking encourages index-hugging and, during bull markets, rewards those investors who have portfolios that are most closely linked to the underlying benchmark.
Some hedge funds, on the other hand, do not benchmark their portfolios;Â Seth Klarman (Trades, Portfolio) is an example. The goal of Baupost is to achieve a positive absolute performance year after year without trying to mirror the broader equity market. The fund's returns show that not only have Klarman and team been able to accomplish this goal, but also outperform the S&P 500 over the same period as well. Klarman has been able to use this approach as he has cultivated a base of investors around him that allow him to do how he pleases, without any option to withdraw their money at the first sign of underperformance. In many ways, this is similar to an average personal portfolio. If you do not have any investors to please, why should you try and beat a benchmark rather than investing according to your own experience and long-term goals.
The experience factor
Experience is a crucial marker in this respect. If you have only been investing since the financial crisis, you do not have enough experience to have tested your strategy through all environments. For the past decade, value investing has underperformed growth, but we do not know if this will continue when the next bear market emerges -- if it ever does.
You may have underperformed over the past decade by following a value strategy, but will this continue to be the case if the market drops by 50% tomorrow? Maybe not. It is a waste of time and money to jump out of value into an index fund because you have been underperforming the broader market for a few years, only to find out if you had stayed with the same strategy you would now be outperforming. You can only make the judgment if you have tested your policy through a full market cycle.
Should you be benchmarking?
The answer to the question of whether you should benchmark or not is not going to be the same for every investor.
Some investors with more experience than others will feel comfortable benchmarking their returns. Another strategy could be to target a per-annum return of, say, around 5% or more no matter what the market environment. Some famous investors, including Warren Buffett (Trades, Portfolio) and Peter Lynch, have followed this path with outstanding success. Or you could adopt Klarman's approach of targeting a positive annual absolute performance every year with no specific target.
The one thing that links the three investors above is not their returns target, but their bottom-up approach to investing. All three only look for investments where the chance of return is significant (Buffett is buying $1 for 50 cents, for example). This is not benchmarking per se, but it does give a targeted return for each investment, which should translate into a targeted return for the overall portfolio. For most investors, this method might be the best approach as it builds a margin of safety into all of your positions. You are not benchmarking, but rather targeting a double-digit return on a position-by-position basis.
