As I've been doing research to better understand benchmarking and what individuals should and should not do, it was interesting to me how individuals actually did this. My methodology was very unscientific, largely based on conversations that I've had with acquaintences and friends, but also looking at what people ask on forums like Reddit in the Personal Finance board.
During these conversations, almost to a person, the tendancy was to measure the performance of their portfolio was based on the performance of the S&P 500. Everyone was also only talking about the performance from a return perspective, not from a risk perspective.
One of the tools on our site is the Sharpe ratio. The Sharpe ratio is a really great tool for understanding the risk adjusted rate of return in a portfolio. This is one of the 2 key elements that individuals tend to not factor in the one or two times a year that they look at their investments. Most people are not familiar with the Sharpe ratio, so a little background on this.
First, the Sharpe ratio is the defacto industry standard for determining this risk adjusted return. The Sharpe ratio represents the average rate of return in excess of the risk-free rate of return. There are few investment vehicles that will actually give you a risk-free rate of return, but one such vehicle are US Treasury Notes and Bonds. The actual formula for the Sharpe ratio is illustrated below:
The standard deviation is used in this formula to measure the risk within your portfolio, but more on that later. The 3-month Treasury Bill is typically used as the measure for the risk-free rate of return. [you can very easily find this rate of return by doing a simple Google search for "3 month treasury bill rate" or you can check Yahoo Finance. As of 9/25/16 the YTD average return would be .258% for the 3-month (or 13-week) Treasury Bill return.
Your portfolio return can typically be found on the website of your financial institution. If you have more than one institution, which most people do, you will need to do a weighted average of those returns, again, more on that later. The reason that most people will have more than 1 financial institution is that your company 401(k) is not always the same institution that you have as an individual.
The other thing that most people do wrong is that they look at 1 or two benchmarks as the measure for how they are doing. For many, looking at the return of the S&P 500 or some other stock index is how they benchmark their return. Every financial institution from Fidelity to Schwab talks about a risk-diversified portfolio, which means that they want you to invest in something other than stocks in order to diversify your risk. A typical rule of thumb (depending on your appetite for risk and your age) is that you are recommended to have 60% of your portfolio in stocks and 40% in bonds. If you follow anything that looks like this, using the S&P as your gauge is not a correct view as you are completely forgetting about the other 40% of your portfolio that is not invested in stock.
Let's look at a couple of simple examples for how to think about your portfolio performance. First, you have to look at and understand the return of your portfolio. You can likely find this out fairly simply by logging in to your investment account and looking for a link to your performance. The images below illustrate what you should look for using examples from Fidelity and from eTrade.
Now lets look at an example for YTD performance. Let's look at a simple portfolio that has an asset allocation of 70% stock, 15% bonds and 15% risk-free (cash/money market). [Please note, this is not a portfolio that we recommend, which is something that will vary based on a broad set of criteria.] In this case, the YTD return of this example portfolio is 5.77%. Many people will now take a look at the S&P 500 YTD return and be upset that this particular benchmark is outperforming the example portfolio since the YTD return is 7.82%. A portion of this portfolio (30%) is not invested in stocks, so looking at the return of the stock market would not be correct. There's 2 other benchmarks that need to be added to the assessment, the US Aggregate Bond Index and the US 3-Month Treasuries Index, which have a YTD return of 5.86% and 0.21% accordingly.
The new comparative return is now 6.38% which is calculated as(7.82% * 70%) + (5.86% * 15%) + (0.21% * 15%). Now let's determine what the risk adjusted return is for the 70/15/15 portfolio from the example above. The Sharpe Ratio formula becomes (5.77 - 0.21) / 10.86. which comes to .511.
There is a page on Yahoo Finance that can provide various risk metrics for you to use. This page is available here. In the example above, i used the 3-year average std deviation for SPY which is a proxy for the S&P 500 index. The Sharpe ratio for the last 5 years on the S&P 500 is 1.22 according to the link above. This means that the risk adjusted return for the 70/15/15 portfolio above lagged the S&P risk adjusted return by 1/2.