Relative Benchmarks and Absolute Benchmarks

Zahid Jafry of Onus Consulting Group made a great comment on one of yesterday’s posts (Picking a Meaningful Benchmark). For those that didn’t read Zahid’s comment, he brought up the point that a relative benchmark allows you to compare your portfolio against a meaningful benchmark whereas an absolute benchmark allows you to monitor your progress towards a certain goal.

If you like, it might be better conceptually to think of an absolute benchmark as a desired rate of return. For example, if you (or you in tandem with your advisor) determine that you need to earn an annualized average of 8% in order to retire at 65 then this is your absolute benchmark (for this goal).

While it is possible to do a great job in picking your individual investments such that your portfolio meets or exceeds your relative benchmark, it might not be good enough if your portfolio performs below your absolute benchmark long term. This could occur if your overall asset allocation is too conservative for your goals.

You’ve probably heard by now that equities are expected to outperform fixed income investments over long periods of time. You probably have also heard that there is a distinct relationship between risk and return, such that if you are expecting higher returns you must expect higher risk as well. (Side note: the reverse is not always true such that if you take on more risk, you might not necessarily get a higher rate of return.)

This leads to the following problem. If your asset allocation is too conservative for your absolute benchmark, you cannot just increase your exposure to equities so that the new allocation’s expected rate of return meets your absolute benchmark because you might violate your risk tolerance. In other words, if the new portfolio’s volatility is too much for your stomach to handle and you sell some investments in a market downturn you might very well be worse off than before. It may have been better for you to consider saving more, retiring later, or planning on spending less in retirement.

Like everything else in life, investing and financial planning is all about weighing trade-offs.

Check out Onus Consulting Group – they are an Investor Awareness Advocacy Group and Advisor Referral Service located in Ontario and they have an interesting story to tell.

Preet Banerjee
Preet Banerjee an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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