My Personal Finance Journey

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Setting Up Portfolio Benchmark

Contributed by mm | April 16, 2007 9:38 PM PST

One of the commentators to my last monthly portfolio update rightfully pointed out that I'm not using the right benchmark to measure my portfolio performance. Given that I'm positioning my portfolio for a sizable exposure to international equity, it is unfair to use S&P 500 as the benchmark. To fix this, I'm going to construct a meaningful benchmark for my portfolio.

As I explained in my "Reengineering My Portfolio Management" series, excluding my employee stock option account, I'm planning my portfolio for the following allocation:

• 50% Domestic Equity
• 35% International Equity
• 15% Cash & Equivalent

To map to this allocation, my benchmark portfolio will include the following components:

• 50% in Vanguard Total Markets ETF (VTI)
• 35% in iShares MSCI EAFE Index (EFA)
• 15% in Cash

To calculate the benchmark, I'm using the monthly close price of both ETFs plus any dividend payout to map out the growth in both equity positions. I'm also assigning a 5% APY for the cash position in the benchmark portfolio.

To compare the return of my benchmark portfolio vs my own semi-actively-managed portfolio, I calculate an index with the baseline of 100 on January 1, 2006.

Here is how my portfolio performed against the benchmark:


There are several take-aways. First, my portfolio tracked closely to the benchmark after 15 months. In fact, my portfolio lost to the index in the first half of 2006 by almost 3 percentage points, but recovered almost everything in the following 9 months.

More importantly, throughout this 15-month period, on average a quarter of my portfolio was in cash. (Did I mention too much cash is my headache?) Therefore, case can be made that my portfolio generated (almost) the same return with lower volatility.

If I compare my portfolio's return to a similarly allocated model portfolio (45% in domestic equity, 30% in international equity and 25% in cash), my portfolio actually returned more than 1.3% during the period.


Anyway, 15 months is too short a timespan to draw a conclusion on the performance. The purpose of this exercise is to construct a benchmark index to compare my portfolio's performance against. You can count on me to report my score vs the benchmark in future monthly portfolio updates.

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This Post Has Received 11 Comments. Share Your Opinions Too.

joewatch Commented on April 17, 2007

This is great. I'd like to do the same for my portfolio. What software / website are you using to track the model portfolio?

CPA1298 Commented on April 17, 2007

MM - I'm really glad you're doing this. It will be very interesting going forward to see how you do. I'll make the forecast now that you'll under-perform the index by at least 100 basis points on average. From the 2nd graph your portfolio ended ahead of the 45-30-25 benchmark only 2 months out of 16. If you were playing baseball you'd be batting .125.

Regarding the comment regarding lower volatility, did you calculate the standard deviation of your portfolio vs. the benchmark, or are you using qualitative factors to make this assessment? I'd be curious to see what each portfolio returned in terms of % return / standard deviation.

I think right now that it is very hard to find compelling investment options in any asset class, and that maintaining a large risk-free pool of cash is not a terrible place to be. You mentioned dollar-cost-averaging the cash into equities; this is probably the best bet, maybe over over a span of 2-3 years or so. Everything is priced so high right now, I'd be afraid to put a lot of cash to work immediately, especially in foreign/emerging markets.

jj Commented on April 17, 2007

Your results show no statistically significant outperformance whether modelled with your true cash allocation or your goal. Even with a 1.3% outperformance quaoted you would need to demonstrate that consistently for roughly ten years for it to be statistically significant. Why not save all your time and just invest in your benchmark ETFs? It would have solved your "too much cash" problem last year as you searched for suitable investments.

The other way is to put 90% in your benchmarks and actively manage the remaining 10% so you can continue to develop active investment skills. When you have a statistically significant outperformance in the 10% that is the time to actively manage the remainder.

joewatch Commented on April 18, 2007

Something to strongly consider when you decide to make shifts in your portfolio is what the tax consequences are. If you have been investing for 10 years, you could easily have a 40-100% capital gain that you will owe taxes on. If MM is doing OK with actively managed mutual funds, the loss to capital could easily outway any gains he could potentially make from switching to ETFs or index funds. It would be better to keep what he has and to plan to dedicate any future purchases to index funds/ETFs.

CPA1298 Commented on April 18, 2007

MM - I'm not sure how you don't qualify as an 'active' investor; as far as I can tell, only about $6,000 of your $750,000 portfolio is invested in index funds. If I were you, I'd sell all the equity positions (to the extent possible), put $600k in the IFA 100 portfolio, and plan on dollar-cost-averaging the leftover cash into the IFA 100 over the next few years.

I apologize for mis-reading your graph, and for always seeming so cynical. I really appreciate the service you provide by laying your financial life bare for the world to pick apart.

John Commented on April 18, 2007

I would stick with the S&P500 benchmark. Sure you don't take the varying risk into account, but you get an idea of whether its worth your time to bother actively managining your funds.

The two basic options you have are to either:
1)wory about picking stocks/funds/diversifaction into international markets
2)just dump everything you earn into a bread and butter ETF (likely tracking the S&P500)

Otherwise, what's the point of personal benchmarking? Generally you seem equally interested in your return on time, as well as return on capital. Even with 700k in assets, maybe you have something you could do with your time that returns more $/hour than personal asset allocation?

Gnom Commented on April 18, 2007

If you have no passion for learning businesses in-depth, identifying and owning best of the bread. If being an average and be averagely paid in exchange for doing nothing, settles fine with you. IFA 100 is a way to go.

However, for those adventurous, persistent souls who wish to learn it would be a poor proposition.

Of course benchmark is helpful to know where you stand compared to the average, but there is no need to be mesmerized by it, especially if you got privilege of time.

Here is a quote I like - �Formula for success: Rise early, work hard, strike oil.� -
Paul Getty.

EI Commented on April 19, 2007

I would agree with John on this one.
The S&P is one of the best benchmark available and should give you a correct comparative mark. Of course it is not optimized. But to some point, tracking results should not take too much of your time.

CPA1298 Commented on April 19, 2007

It seems that there are two debates going on here.

1) Should MM benchmark against the S&P500, or something else?
2) Should MM be an active or passive investor?

I don't see how there can be any debate as to the first question; MM has a portfolio that is heavily weighted to foreign equities; therefore, to see if he is making progress, he should compare himself to a benchmark that reflects the performance of such a portfolio. There isn't a lot of room to debate the logic of his (correct) decision to compare the return of his portfolio against a blended return, as provided by the S&P500 and MSCI EAFE, which are both widely-followed and tracked.

The second question is probably the most hotly debated dilemma in the history of finance. MM has sealed the debate regarding his portfolio; he feels that with time, education and experience he will perform better than the market. That is fine; he as about $650,000 more investable dollars than I do, and he can do what he wants. However, both academic theory and historical performance (of investors in general, not MM specifically) would indicate that MM will fail to perform at or above the index averages, but he (and we) will certainly have fun watching him try.

RefinancingTips Commented on April 28, 2008

Great read. I think I'll subscribe to this as it has some good info! Thanks. I do apppreciate the blog :-)

RefinancingTips Commented on May 2, 2008

Great read. I think I'll subscribe to this as it has some good info! Thanks. I do apppreciate the blog :-)

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