How to lose by beating the benchmark

I beat the benchmark massively last week.

I’ve started swimming again, which has meant regaining ground previously owned. This past week I set recent records in both (speed and distance), which was a huge improvement for me.

By Christoffer Engström

Let’s be clear: there is no chance I could beat Michael Phelps even if he had one arm tied behind his back. There are people in my pool who are faster than me. When I’m swimming I feel the urge to match their speed, even when I know I’m covering a longer distance. But I can’t sprint a marathon, and trying to match them will just lead me astray from my true goal.

This idea is critical. We should be benchmarking and improving on our own performance relative to our own goals. Not others.

Every day we are presented with benchmarks that have nothing to do with our goals, yet challenge us to beat them. It takes real thoughtfulness and control to craft a benchmark for yourself, and measure performance relative to it, not others.

Public benchmarks are easy (and misleading)

When you want to know you’ve made a good decision as an investor, we need to compare it to an alternative - a ‘counterfactual’ of what could have been. And you’ll have plenty of material to work with. You can’t listen to a news update without hearing what markets (the Dow and S&P 500) have done. You can easily look up the performance of funds, indexes, even hedge funds and endowments. You can use a free investment aggregator to do it for you, and the aggregator will likely email you weekly. If you’re lucky enough to be the target of investment advisor, they’ll be constantly showing backtests of what could have been your portfolio, if only you’d invested with them (and they happen to have done well lately).

I think it’s now too easy to compare our investment performance. If you want to find something that beat your portfolio over some horizon, you can. One of the bitterest truths in investing is that with hindsight, a diversified portfolio will never have been the best thing to invest in. Being diversified is a way to reduce risk because you don’t know the future. It hedges out all the concentrated risks that could really hurt you.

Should you compare your portfolio to the best performing asset, or the worst? Should you compare it to a U.S. large-cap stock index like the S&P 500, or a global stock market index like the All Country World Index? Should it be float adjusted?

I’d think you that you probably shouldn’t care at about those benchmarks at all. Unless you’re job is being a fund manager, it’s unlikely “beating the S&P 500 for 10 years straight” is what will determine your success in life.

Personal benchmarks are hard (but correct)

How can you beat a public benchmark, yet lose against your personal benchmark? Money is only useful inasmuch as you can convert it into happiness, and how that conversion happens matters a lot.

Consider Jon, who wants to ensure he can pay for his newborn’s college. Jon has had some good results playing the stock market, and believes he can continue to beat the S&P 500 by about 1% per year.

Jon considered a 529 plan, where he’d have to use a target date fund. He can’t generate outperformance using a fund like that. So Jon opted to save in a taxable trading account. He calculated how much he’d need to save each month, given his expected 7% return (6% for the index, plus his 1% outperformance).

Over the next 10 years, he does manage to beat the S&P 500 by 1% on average, per year. So he’s won! He beat the index!

Yet he doesn’t have what he planned for his daughter’s college tuition. What happened here?

There are three possible contributors to this outcome in my made-up scenario.

Undersaving: First, and most importantly, Jon didn’t save enough. He bet on being able to make 7% returns on average every year. Higher returns mean you can save less, and so he under-saved. Saving is the single success factor we have complete control over, yet it’s the one we spent the least amount of time optimizing.

Too much risk: Second, he beat the market, but only by taking on too much risk for the goal. If the market fell 20% in the last year, it’s not going to matter that he beat it by 1% - he’ll still be down 19%! This is far too big a loss to recover from before the money is needed.

Taxes: And finally, he didn’t consider the tax implications of all his trading. While his investment dashboard shows him beating the market handily, each year he incurred short-term capital gains, and all his dividend income was taxed. Each year he paid more in taxes, which had to come out in reduced savings from somewhere. If he’d used a 529 plan, that wouldn’t have been the case. So after he’s paid for all those taxes, he might have beaten the market, but he under-performed the target date fund in a 529 plan in take-home money.

How to craft your personal benchmark

It order to measure and generate true outperformance, you need a personal, focused benchmark you can follow. As my colleague Mychal Campos recently wrote:

For most people, investment success is much less about excess returns relative to a benchmark, and much more about building a desired amount of wealth over a given time period.

Crafting a personal benchmark is work, but it’s worth it. A personal benchmark is also much more effective at ensuring you’re on track in your life for things that matter to you. Indeed, having a goal helps you stay on track through good and tough markets.

On track for the future, not just further from the past

Most of the time we look at the difference between two past outcomes. We look at what happened (our account), and what could have happened (the benchmark), and compare them. The result is a comfortingly sharp comparison. How do you construct a personal benchmark? I tend to use two approaches:

Personal historical performance

Desired versus achieved change in after-tax wealth.

It isn’t just about investments; it includes how much I’ve managed to save, my returns, and the reduction in wealth by taxes I’ll have to pay when I liquidate the goal. It let’s me know if I personally have done better or worse than expected. I can compare it to what I though would happen, and it won’t mostly be noise from the market.

On track for the future

Am I on track for achieving what I want, or do I need to make a change to be realistic? The next benchmark asks if you’re on track for the future. If you changed nothing, is there a reasonable chance of achieving what you want? This looks at the distance between where you are, and where you want to be.

The toughest part of a personal benchmark is that it’s primarily about the future. This means no ‘facts’ exist, and the counterfactual is even harder to construct. But there are some questions we can ask.

What is the shortfall risk?

A shortfall is the gap between how much money you’ll need, and you’ll have, in the future. A shortfall analysis generally means taking a look at downside market scenarios (below average, or even negative), and checking if you’ll still be ok. A projected shortfall, and whether or not that shortfall is manageable, is critical.

What is (potentially) in your future?

While we certainly don’t know the future, most financial planning is about most effectively hedging our those risks. An emergency fund and retirement goal are the most universal.

After that it get’s personal. Are you likely to get married? Buy a house? Make a big change, moving cities, countries or careers? Is it possible you’ll have a child? A second child? Will your partner want to leave the workforce to care for the wee ones? Will they need financial help in college? Will you need to support your parents, or another family member? Will you want to take a career break?

The odds are nearly 100% you’ll experience at least 2 of these. But you probably don’t think about the possibility of them until they are almost a certainty.

How the money will be used

How the the money will be used is important, usually because of tax planning. For retirement, you have the acronym salad of 401(k), 403(b), IRAs, Roth, Traditional, SEP, Solo, MyRA. For college you have 529s. For health you have HSA, FSA, and so on. All of these are better ways to save and invest, given that you know why you’ll be spending the money.

Are you doing better than you used to, in areas that matter?

Are you enjoying your job more? Are you making more money than you used to, and are you saving a higher proportion of it? Are you doing less of the things that you don’t enjoy? Are you spending time doing things that make you a better person? Are you investing in yourself through learning or practice? Are you contributing (time, money) to your family, community, friends and professional network?

A personal benchmark includes considerations of personal efficiency - achieving more with less. And that includes you’re time and effort.

Good personal benchmarks are addictive.

In a good way.

A big benefit of a good personal benchmarks is that they make beating the benchmark much more common, controllable, and rewarding. If my goal isn’t to beat a market index, but rather to beat how much I saved last year, I have a much higher chance of success. And in the case that I am successful, I can attribute more of my success to my actions, rather than randomness.

And feeling good about making progress at a personal level means you’re more likely to continue to make progress. It makes personal progress itself addictive.

And that’s why this week, I’m going to try to once again outperform. And it’s very possible I will.