Benchmarking

What it costs to never benchmark your portfolio

A fund manager who trails the index for three years has to explain it. A private investor does not, because nobody checks. The gap between a portfolio and an index fund keeps compounding whether anyone measures it or not.

Professional money is audited all the time. Every pension fund, every mutual fund and every mandate has a named benchmark, and performance against it is reported and discussed. Private portfolios have no such mechanism. There is no quarterly review, no board and no client, and most private investors believe they are doing fine.

This article puts a number on what a small yearly gap costs over twenty years, explains why the gap gives no warning, and describes what it means to benchmark your portfolio in a way that measures your decisions rather than your deposit dates.

What a gap of 2% a year costs

Say your picks trail a simple index fund by 2% a year. On a €50,000 portfolio that is €1,000 in year one. It goes unnoticed, because you are still up in absolute terms. Twenty years of compounding later, the gap is a five-figure sum.

In round numbers, €50,000 compounding at 7% a year becomes about €193,000 after twenty years. The same €50,000 at 5%, the same market minus a 2% gap, becomes about €133,000. The difference is roughly €61,000, more than the original stake.

Both accounts went up in most years. Both owners would describe themselves as successful investors, and at no point did anything feel wrong. The difference between them is €61,000.

Underperformance in a private portfolio produces no signal. A losing year is visible on every screen. A winning year that should have been a better winning year looks like any other winning year, and the absolute return your broker shows by default cannot reveal the difference.

Why nobody benchmarks by default

The first reason is that the tools do not. Broker apps show your gain since purchase, sometimes a chart of account value, and stop there. An account value chart mostly tracks your deposits, so it goes up as long as you keep contributing, which says nothing about your decisions.

A proper comparison replays your own cash flows into an index. That requires your full transaction history and daily index data, and no broker has an incentive to build a screen that might show that an ETF would have done better.

The second reason is that bull markets hide the gap. When everything rises, every strategy looks validated. A decade in which the index compounds at double digits makes almost any collection of large-cap stocks feel like skill.

The third reason is memory. The winners are still in the app, on display. The losers were sold and left the screen, and the loss went with them. The difference between realized and unrealized gains shows how much of a portfolio's history lives in the closed positions nobody revisits.

What it means to benchmark your portfolio

Comparing the S&P 500's yearly return with your app's percentage is not a benchmark. The two numbers do not measure the same thing, because the index assumes a lump sum and your money arrived in installments.

A proper benchmark replays your deposits and withdrawals into an index tracker on the same dates. The result is a simulated index portfolio that received your money when you did and made none of your decisions. You then compare the two end values.

Done this way, the comparison isolates the one thing you control, which is what you did with the money after it arrived. Your deposit timing, lucky or unlucky, appears on both sides and cancels out. What remains is the result of your decisions, a number the app's percentage never shows.

The mechanics, with a worked example, are in how to check whether you are beating the S&P 500. The related distinction between time-weighted and money-weighted return, the two ways to grade a portfolio, is explained in time-weighted vs money-weighted return.

The three possible outcomes

Once you benchmark properly, you land in one of three places.

You are ahead. The lead comes from your selection and not from deposit timing, because the timing is the same on both sides of the comparison.

You are behind by a little. This is the most common result. The question it raises is whether stock-picking is a hobby that is worth about 1% a year to you. That question now has a price attached to it.

You are behind by a wide margin. Usually the cause is one or two positions, or a pattern of selling winners early, and the transaction history shows which of the two it is.

Each of these outcomes is more useful than not knowing. Benchmarking puts a price on a decision you already make every month by default.

Many people who see the number keep picking stocks, either because they are ahead or because they have decided the engagement is worth a measured cost. What changes is that the cost is a known amount instead of a guess.

If part of the portfolio is in index funds, the overlap between those funds is a separate question, covered in how to check the overlap between your funds.

The index to compare with

The benchmark is the index you would hold as the alternative. For most people that is a world index or the S&P 500. For a tech-heavy portfolio the Nasdaq 100 is the closer comparison. Benchmarking semiconductor stocks against a bond index proves nothing except that flattering comparisons are easy to find.

The test is practical. If you sold everything tomorrow and never picked another stock, where would the money go? That destination is your benchmark, whatever a textbook might prefer.

The comparison also has to use the total-return version of the index, with dividends reinvested, because your own portfolio keeps its dividends. The price-only chart understates the index and flatters you. The choice between the two large US indexes is worked out in S&P 500 or Nasdaq 100.

How often to look

A benchmark gap over three months is mostly noise. Any diversified portfolio wanders a few percent around its index in the short run, in both directions. A gap that persists over three to five years is a result.

Somewhere between quarterly and yearly is often enough to catch a gap before it compounds into that €61,000, and rare enough not to react to short-term moves.

Consistency of method matters more than frequency. The same benchmark, the same cash-flow replay and the same treatment of fees and closed positions, every time. Switching to a friendlier index after a bad year turns the exercise back into the flattering guess it was meant to replace.

What the three lines show

BullBenchmark replays your deposits into the S&P 500 and the Nasdaq 100 and shows your portfolio, the simulated index portfolio and your raw deposits as three lines on one chart.

The raw deposits line separates growth that came from your contributions from growth that came from the investments. For many portfolios that distinction is larger than expected.

Whether your effort adds to the result or costs part of it is a question that has been open for as long as you have been investing. A broker export is enough to answer it.

BullBenchmark reads the transaction export from your broker and shows your return next to the S&P 500 and the Nasdaq 100, fed with the same deposits on the same dates, in your own currency. The first two weeks are free and no card is needed.