Monitoring the performance of your investments is an integral part of sound financial planning.
Suppose that last year, your portfolio generated a 12% return. Was that good or bad? Well, if you are comparing the performance of your portfolio to GICs, then the return was pretty good. If you are comparing your return to an equity index that returned, say, 20%, then the numbers don’t look so good.
The problem of course, is that most investors don’t have 100% of their portfolio in GICs, nor do they have 100% of their portfolio in stocks. Most have a combination of investments that include cash (Treasury bills, bank accounts), fixed income (bonds), and equities (stocks).
If we accept the position that most investors have a diversified portfolio, then we have to also accept that a 12% return tells us nothing about value. It’s like having a son who is seven feet tall. Is that good or bad? It’s good if he wants to play professional basketball. Not so good if he wants ready to wear clothes.
Knowing a quantity such as how tall, how much, percent return, and so on tells us nothing about value. Only by comparing a diversified portfolio against a passive portfolio benchmark, can you make an informed judgment about how well your portfolio did. If your passive benchmark returned 11%, and your portfolio returned 12%, then your portfolio did very well indeed.
A benchmark is simply an independent standard against which performance can be evaluated. A good benchmark has five essential characteristics:
- Unambiguous → The components are clearly specified
- Appropriate → It is consistent with your objectives
- Measurable → Performance can be established frequently
- Current → It is based on marketable securities
- Investable → It can be replicated and the components can be purchased separately
At Croft Financial Group we use what we call the “Croft Real World Indexes” as our passive benchmarks. These are three globally diversified index-based portfolios based on the FPX Indexes originally co-developed by Richard Croft. These indexes are diversified by asset mix and geographic region, and are re balanced annually. What makes these benchmarks different is that they are investable, and they include a basket of index-based exchange traded funds. The Croft Real World Indexes take the process a step further and adjust the FPX Indexes for a 1% management fee, about the average fee paid by Canadian investors for portfolio management.
When we talk about asset mix, we are really talking about the percentage of the portfolio that should be allocated to cash, to fixed income, and to stocks. The asset mix is critical, because it determines 85% to 90% of the total return of your portfolio.
Unfortunately, most investors spend too little time understanding asset mix. They buy a specific fund or a certain stock based on its past performance or its potential return. The asset mix is determined by default.
Typically, investors fall into one of three basic categories: conservative; balanced; or growth. You can argue, as some financial institutions do, that three categories are too generic. However, we believe that each client deserves a personalized asset mix that can be accommodated by fine tuning the weightings within our three categories. Bottom line, asset mix is the priority, and for every client there is an appropriate personalized asset mix.
Accepting the position that there are three typical investor categories, each category has its own unique character.
CONSERVATIVE INVESTORS, for example, want a low-risk income-producing portfolio. They lean toward investments that provide regular returns, even if these returns are low. While others dream of wealth when they invest, conservative investors are motivated by the dread of poverty. Protection of principal is paramount.
We often find retired investors in this category. Either they are building a portfolio for estate planning purposes or they are drawing an income to supplement their living standard. The generally accepted asset mix for a conservative income investor is 20% cash, 50% fixed income, and 30% equity.
BALANCED INVESTORS pay attention to the income side of their portfolio, although generally it is not considered a critical supplement to their standard of living. At least not yet! Often, the balanced investor will simply reinvest the portfolio’s income stream, effectively dollar-cost averaging their investment program.
Balanced investors understand that financial security depends on some growth being attained within the portfolio. To that end, they will spend a great deal of time understanding how much return is required to meet their long-range objectives. They often set more reasonable goals that for the most part can be attained with their investment style. The generally accepted asset mix for a balanced investor is 10% cash, 40% fixed income, and 50% equity.
GROWTH INVESTORS are not at all concerned about income. Usually, they have a long time horizon and often a sizeable net worth. The objective is to maximize the potential growth within the portfolio, taking reasonable risks.
Growth investors have an appreciation for the trade-off between risk and return, and are willing to assume higher levels of risk if it results in better performance. The generally accepted asset mix for growth investors is 10% cash, 20% fixed income, and 70% equity.
The Real World Indexes provide the investor with a reasonable benchmark against which compare how well their particular asset mix is performing. That’s important information, because investors are keenly interested in knowing if the advice they are getting is adding value to their portfolio.
What this means is that now, when you ask, “Is a 12% return is good or bad?” the Croft Real World Index benchmarks can go a long way to giving you an answer.