Remember, the true point of reference is you

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When you make an investment, you are making a short-term sacrifice for long-term gains.

But when you look back, how can you know if you really won? The mere fact of having achieved a positive performance is not enough (although it is a start). In finance, you have to remember that everything is relative: if I gained 7% when my reference market made +10%, I shouldn’t be entirely satisfied.

In most cases, investors spend their time reviewing returns against a designated benchmark. But this can lead to a biased comparison, where the wrong things are compared in the wrong time period.

Let’s imagine a scenario where you earned 7% in a given period of time. It was a success? Maybe. What if we throw in the idea that the return was 4% below the previous year, 3% above the average of portfolios of the same type, 2% above inflation and 1% below the desired level of profitability? Should we consider it a success?

Add to that the fact that, hypothetically, only one asset among all those in the portfolio is attributable to total return. Then imagine that your portfolio took on more risk than expected by increasing short-term volatility at certain times of the year. Is it still a success? It’s hard to say.

a complex territory

This example helps illustrate the complexity of proper benchmarking. There are many variables, some of which you can control: the risk you take, the resources you have, and the time frame. Others, however, cannot be controlled.

“As individuals, it’s important that each of us can measure our own success in a way that’s appropriate to the circumstances,” says Dan Kemp, global chief investment officer at Morningstar Investment Management (MIM).

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“Ideally, this will include a robust and repeatable framework, which may or may not use benchmarking tools. The list at your disposal is theoretically endless, although they must be appropriate.”

The ideal reference point

In 2012, a study published by the State Street Center for Applied Research, titled The Influential Investor: How Investor Behavior Is Redefining Performance, sought to define the forces that would change the financial services industry.

The report noted that while relative performance as measured by classic benchmarks serves the management firm, investor views are more complex, reflecting their personal mix of search alpha, beta generation, downside protection, and asset management. assets.

Against this background, the study showed that for investors, portfolio performance is the main tool by which they judge their asset manager, but it can also be a weakness.

Simply put, the same return has different effects on different investors.

Let’s try an example: Mrs Sandy is 60 years old, has an income of £2,000 per month, has three children and has not yet finished paying off her mortgage. Mrs Keylock, on the other hand, is 40 years old, has an income of £3,000 a month, has no children and inherited her house, so she is not paying any debt.

The two have invested in the same fund, which has been losing 5% since the beginning of the year. This outcome will have very different effects on the personal balances of Mrs. Sandy and Mrs. Keylock, and is clearly heavier for the former. Same absolute performance, different relative performance.

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Try it for yourself

The best benchmark is one that looks to the future while remaining aligned with identified financial goals. In a perfect world, every investor would have their own bespoke dashboard to measure the success of their investments, with transparency and insight.

The challenge is that prospective valuation is incredibly difficult to quantify and there is no one-size-fits-all approach. Classic benchmarking tools (relative relative, relative index, absolute performance, actual performance) are useful, but limited. What matters to investors is whether they can expect their investments to help them achieve long-term returns in the future.

“This mismatch requires attention and highlights an important point about process versus outcome,” explains Kemp.

“Specifically, it is entirely possible to have a strong process or good decision with a bad outcome, just as it is possible to have a poor process with a strong outcome. However, more often than not, a strong process will prevail and result in strong results, and vice versa.

“This is a key reason we emphasize that people should make comparisons over a longer time horizon: it allows the strength of the process, and the combination of many decisions, to reveal itself.”

To give concrete impetus to this concept, MIM EMEA analysts have developed a checklist to reinforce the link between objectives and investments, which can be used as a starting point to build a method of evaluating your own financial performance. or that of your clients.

Checklist: Align your framework with your ambitions

  • Is there a clearly defined financial goal that you can aim for your portfolio?
  • Are you evaluating the results of your investment in an adequate time horizon?
  • If you are using a benchmark, is it realistic and invertible?
  • Is it necessary to take inflation into account?
  • Have you taken into account the risk assumed?
  • Does your portfolio stand out strongly in a prospective context?
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Checklist: Avoid Emotional Bias

  • Can you avoid the recency bias, where you focus too much on the recent past?
  • Are you aware of your own loss aversion and avoid selling in a panic?
  • Can you avoid the overconfidence bias and avoid assuming that you were the key factor in your success?

All things considered, proper benchmarking is a powerful tool, both analytically and behaviorally.

“If done correctly, it can help investors stay on track and focus on the right things, but if done incorrectly, it can have significant consequences,” Kemp concludes.

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www.morningstar.co.uk

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George Holan

George Holan is chief editor at Plainsmen Post and has articles published in many notable publications in the last decade.

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