One of the biggest challenges you face as an investor is determining how well you’re performing. Sure it might be nice to see your portfolio is “up 12%,” for example, but how do you know you couldn’t have done better?

The primary solution to this problem is to create or find a benchmark against which you can evaluate your portfolio’s performance. In theory the benchmark you choose should be appropriate for all your investment managers.  Unfortunately it’s almost impossible to develop one benchmark for all investors.

Benchmarks are relatively straightforward when you want to measure the relative performance of a money manager who only invests in one asset class like US stocks or bonds. It gets far trickier when you want to evaluate the manager of a diversified portfolio.

Indexes

Most individual investors think they should benchmark their diversified portfolios against a stock index like the S&P 500®. That’s probably because such indexes are the only indexes with which they are familiar or the only indexes their financial advisors used in the past.

Unfortunately using a stock index as a benchmark for a diversified portfolio is like comparing apples to oranges.  A pure US stock portfolio has a particular expected return and volatility (risk) profile. A well-managed diversified portfolio should have a slightly lower return than a US stock index and significantly less volatility. The only fair way to evaluate the two types of investments is on a risk adjusted return basis.

Enter the Sharpe Ratio

The Sharpe Ratio was created by William Sharpe. the co-recipient of the Nobel Prize awarded for the creation of Modern Portfolio Theory. to evaluate the relative attractiveness of individual asset classes and portfolios.  It is calculated as follows:

The Sharpe Ratio for the S&P 500 over the past 15 years was 0.19.  The Sharpe Ratio for the portfolio Wealthfront recommends to our average investor would have been 0.28 over the past 15 years. That means the average investment portfolio on Wealthfront could have outperformed the S&P 500 by almost 50% on a risk adjusted return basis. *

Sharpe ratios are used extensively by institutional investors to evaluate the performance of their portfolios and component asset classes.  Unfortunately most individual investors are not familiar with the Sharpe Ratio or conditioned to evaluate their portfolios’ performance in terms of risk AND return.  As a result a number of other lower fidelity approaches have been created to help benchmark diversified portfolios.

The traditional approach

The most common approach to benchmarking portfolios is to compare a client’s portfolio to a portfolio that consists of 60% stocks and 40% bonds.  Typically the S&P 500 is used for the stock component and the Barclays Aggregate Bond Index for the bonds.  The problem with this approach is a 60/40 allocation usually doesn’t have the same risk profile as the portfolios against which it is compared.  An investor with significant risk tolerance (say an 8 on Wealthfront’s 10 point scale) should expect both a higher return than a 60/40 portfolio and greater volatility.

Market weighted benchmarks

I had lunch with Bill Sharpe a few weeks ago (Bill and I are colleagues at Stanford Graduate School of Business and previously served together on the board of a financial technology company) and he told me for less sophisticated investors, he currently favors comparing portfolio returns to a portfolio that is weighted by the relative aggregate worldwide market capitalizations of all major asset classes.  Unfortunately this approach also doesn’t address the issue of different investors having different risk tolerances and the required data is challenging to find (Bill is working to make it broadly available).

It probably makes the most sense to compare your portfolio to a mix of indexes based on your particular level of risk. On Wealthfront, that IS the portfolio we manage for you.  It doesn’t make much sense to compare your portfolio to itself.

Projections

That’s why we decided to compare your portfolio to the original projection we provided when you opened your account.  The projection is relevant for your particular level of risk and you can judge us relative to what we said we could do for you.  The downside of this approach is twofold.  First, no advisor can foretell the future and the markets for securities can be much better or worse than expected.  The projection approach will penalize an advisor who does relatively well in an environment where long-term results are worse than expectations.

Second, volatility can have a disproportionate impact on your short-term performance, which can make your results look a lot worse or better than they ultimately will be compared with a projection.  Therefore using a projection as a benchmark is only appropriate for judging long-term performance (but you shouldn’t evaluate your investment returns over a short time period, anyway).

The debate wears on

If you are a current client of a financial advisor, especially one who works for a brokerage firm, it’s unlikely your portfolio’s performance is measured against any kind of benchmark, be it an index, blended index or a projection.

That is probably for a combination of reasons. Most financial advisors worry, perhaps rightly, that you will be overly focused on your short-term results, which as I explained above can vary widely and which aren’t the best way to judge performance. Over the long-term, a benchmark can help reveal an advisor who isn’t doing a good job – another reason that bad financial advisors avoid using them.

If your advisor doesn’t use a benchmark, you should ask which one she thinks is most appropriate. A good advisor will be willing to educate you on the topic. If she still argues against using one, then you might be well served to look elsewhere.

As I said at the outset, none of the benchmarks (including the one we use) are ideal, which is why the debate over which benchmark is best wears on and why people like Bill Sharpe are still working on the problem.

The advice we can provide with confidence is you shouldn’t compare your diversified portfolio’s performance to that of an individual asset class’s performance.  We’d love to hear your thoughts as to what kind of benchmark you would like to see to help us fulfill our commitment to continuously improve our service.

* Disclosure

To achieve the hypothetical Sharpe Ratios described here, we measured returns for two portfolios for a 15-year period (from 1998-2012): the S&P 500 Total Return, which consists of one asset class, and a Wealthfront taxable portfolio, consisting of six asset classes, with a risk score of seven.  We assumed monthly rebalancing in the Wealthfront portfolio.  In both portfolios we considered expenses and assumed that dividends were reinvested.  In the Wealthfront portfolio, we considered advisory fees.

After we measured the simulated historical monthly returns of both investments over the 15-year time period, we were able to calculate the Sharpe Ratio for each portfolio using the formula described above.  We assumed the “risk free rate” in the formula to be the three-month Treasury bill rates.  For the 15-year period, the Sharpe Ratio for the S&P 500 was 0.19, and the Sharpe Ratio for the Wealthfront taxable portfolio was 0.28.  This hypothetical calculation does not take into consideration the effect of taxes, changing risk profiles, or future investment decisions. This simulation does not represent actual client accounts and may not reflect the effect of material economic and market factors.  The results are hypothetical only. The results of this simulation should not be relied upon for predicting future performance and is not a guarantee of actual performance.

A different methodology may have resulted in different outcomes.  For example, we assume that an investor’s risk profile and target allocation would not have changed during the time period shown; however, actual investors may have experienced changes to their allocation plan in response to changing risk profiles and investment objectives.  Furthermore, material economic and market factors that might have occurred during the time period could have had an impact on decision-making.  Actual investors on Wealthfront may experience different results from the results upon which we based our calculations.

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