The Error-Proof Portfolio: 5 Benchmarking Pitfalls to Avoid

You have been checking your 401(k) balance, and it has been growing nicely for as long as you can remember. Perhaps an early retirement is in your future?

Meanwhile, your 401(k) statement shows your portfolio's return relative to the S&P 500, and you're lagging that benchmark by a healthy margin since you started contributing to the plan 10 years ago. Hmm, maybe you're not doing so well after all.

Should you be breaking out the champagne or crying in your beer? The answer, it turns out, hinges on finding the right benchmark, and neither viewing your 401(k) balance in isolation nor comparing your return to that of a pure-equity index does the job.

Yes, your 401(k) balance is higher than it was a few years ago, but that figure encompasses your own additional contributions, in addition to any investment returns you've been able to earn. Those contributions may make you look and feel smarter than you actually are. (This is particularly true if you're fairly early in your investing career and your contributions are a meaningful component of your account balance.) Moreover, strong equity and bond markets have lifted nearly every boat over the past five years, so you would have had to go out of your way to not increase your portfolio's balance by a healthy margin.

Meanwhile, unless your portfolio consisted entirely of U.S. large-cap stocks--for which the S&P 500 is a decent yardstick--it's a mistake to beat yourself up too much for lagging the index. If your portfolio includes any bonds at all, it's a given that it will have underperformed a pure-equity index over the past 10 years.

Benchmarks, it turns out, can play mind games. As you consider charting the success or failure of your portfolio or of any individual holdings, or using benchmarks to keep track of your account's positioning, here are five pitfalls to avoid.

Pitfall 1: Losing Sight of the Big Picture 
Benchmarking mistakes aren't the exclusive domain of rookies. Even if you've custom-crafted a benchmark of index funds that exactly mirrors your portfolio's exposures, or hand-selected a peer group of funds to help you better judge the performance of one of your quirky holdings, your benchmarking may still be inadequate if it fails to answer the following questions: How am I doing? Am I on track to hit my goals? Spending too much time evaluating the performance of individual holdings could distract you from those central issues.

If you're in accumulation mode, your main yardstick should be whether all of your retirement-account balances aggregated together, along with your planned ongoing savings, put you in a good position to retire when you plan to. If you're already retired, you'll want to focus on whether your current spending rate is sustainable given your portfolio's current value. Tools like T. Rowe Price's Retirement Income Calculator can help you do a sniff test that should precede other types of benchmarking.

Pitfall 2: Not Doing a 'Simplicity Check' 
Even if your portfolio is faring well from a big-picture standpoint, it's always worth asking whether you could have achieved the same results more simply and/or more cheaply. The right benchmarks can help you do that.

To check up on whether your retirement holdings could be simplified, compare your results to that of a good target-date mutual fund, such as those from Vanguard or T. Rowe Price, geared toward someone in your same age band. Of course, if you're employing an asset allocation that's dramatically different from a target-date fund geared toward someone in your age band, you'll want to find another simple benchmark; funds in Morningstar's conservative-, moderate-, and aggressive-allocation groups can serve as simple yardsticks. If you find that your performance is perennially lagging one of these simple benchmarks (and you're also spending a good deal of time on portfolio oversight), simplifying your investment mix should be on your to-do list.

In a similar vein, I'm a believer in creating a custom benchmark composed of ultra-low-cost index funds or ETFs that mirror your portfolio's asset allocation, as discussed here. Doing so helps you see if your security selection is adding value above and beyond what you'd be able to obtain by buying a mix of well-diversified, inexpensive index funds. Even if you're not interested in skinnying down your portfolio to a one-fund solution, as discussed above, persistently losing out to a stripped-down portfolio of index funds should be a cue to shift into a similarly basic portfolio.

Pitfall 3: Not Keeping Them Up to Date
Even if you take an extremely hands-off approach to portfolio management, you probably make a few tweaks to your positions on occasion. For truth in benchmarking, it's important to keep track of your actual performance, factoring in the purchases and sales, while also keeping your benchmarks up to date based on whatever changes you've made.

For example, say you've created a blended benchmark of basic ETFs mirroring your portfolio's asset-class exposures, as discussed above. If you make any trades, it's important to make the adjustments to your portfolio in whatever portfolio-tracking tool you're employing, as well as to your benchmark's weightings. Say you've reduced your portfolio's stock weighting as part of a rebalancing plan. Make sure that your information in Morningstar's Portfolio Manager--if that's the tool you're using--reflects those changes, and make the same adjustments to your benchmark, too. (On Morningstar.com, you cannot make changes on an ongoing basis if you're using a Watch List portfolio.) Once you've done that, the "My Performance" tab in Portfolio Manager will be an accurate reflection of both portfolios' performances. (Be sure to factor in any transaction costs associated with your trading, too.)

Pitfall 4: Using Benchmarks for Performance Tracking Only
Of course, benchmarks are essential for gauging whether your portfolio is performing as it should. But benchmarks aren't just for performance tracking. Perhaps an even more important use of benchmarks is to guide your portfolio's positioning on an ongoing basis.

An essential benchmark for any portfolio is an asset-allocation target that makes sense given how close you are to needing to spend your money. (This article  discusses how to arrive at a reasonable asset-allocation framework given your own situation.) Periodically comparing your portfolio's stock/bond/cash mix (using Morningstar's  X-Ray functionality to obtain a finely honed view) to that of your asset-allocation benchmark can help you determine whether any changes are in order. Checking up on your portfolio's positioning versus such a benchmark should be one of the key jobs you tackle if you conduct any sort of portfolio checkup, as I discussed in this portfolio checkup video.

Making sure you're aware of your portfolio's major divergences--in terms of its investment style or sector positioning--relative to a broad-market index like the S&P 500 can also help you understand why it's behaving as it is in various market environments.

Pitfall 5: Not Documenting When You'll Make Changes 
Even the best benchmarking system won't be of any help unless you take the next step of documenting when you'll actually make changes to your portfolio plan. If one of your holdings has underperformed its peers for three straight years, for example, will you give it the heave-ho, or give it more time? If you've reviewed your asset allocation and determined that your stock allocation is five percentage points higher than your benchmark, is it time to scale back?

Your benchmarks will only be useful if they go hand in hand with an investment policy statement that delineates when you'll make changes to your holdings. This article discusses how to create an investment policy statement and also includes a link to a template for one.

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