In 2003, Michael Lewis wrote a best-selling book called Moneyball that tells the story of the sabermetric revolution that transformed the Oakland Athletics baseball team. Sabermetrics is a quantitative approach used to analyze baseball players in a more focused way than traditional baseball statistics. Using sabermetric principles, the A’s put together winning teams in the early 2000’s at a fraction of the payroll of most other Major League Baseball franchises.
The genius of sabermetrics is that it measures factors that truly make a difference to the success of a player and a team. Traditional baseball statistics often confuse or conflate who is responsible for a result. For example, pitchers are traditionally measured using something called earned run average (ERA) which is the number of earned runs that a team gives up in nine innings with a certain pitcher. The problem with ERA, however, is that it does not take into account the performance of the 8 other players on the field. Sabermetrics might focus instead on something like field independent pitching (FIP) that adjusts the pitcher’s ERA for strikeouts, walks, and home runs allowed relative to league average results.
I know this introduction might literally be a little too “inside baseball” for some of my readers, but the point I am trying to make goes far beyond baseball. Metrics can help us improve performance in many aspects of life. However, sometimes the metrics we traditionally used to look at things can blind us to opportunities to do things better. This is true for baseball. It is also true for your investment portfolio.
The performance of the S&P 500 stock market index is a metric many people have traditionally used to evaluate their investment performance. If they beat the index, they feel great. If they don’t, they feel bad. In reality, most people don’t know enough about a particular index to know if it is a good benchmark or not.
For example, the first line of the Wikipedia entry for “S&P 500” states:
“The Standard and Poor’s 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 of the largest companies listed on the stock exchanges in the United States.”
That sounds rather cut-and-dried, but the decision about which companies are in the index is much more complex than that. Not every stock in the S&P 500 index is among the largest listed on U.S. exchanges. Stocks included in the index are selected by a committee based on certain criteria, but there are numerous exceptions to the rules and, at the end of the day, inclusion is a judgment call.
There may be nothing wrong with using the S&P 500 index as the benchmark for your portfolio, unless, like most of us, your portfolio contains investments other than large-cap U.S. stocks. To the degree your portfolio contains asset classes beyond large cap U.S. stocks, your benchmark should reflect those other asset classes as well.
When I start working with a new client, one of my first tasks is to establish an investment policy statement that specifies the target asset allocation for the client’s portfolio. Usually, in addition to U.S. stocks, the investment policy will include investing a portion of the portfolio in international stocks and investment-grade bonds. Often, the policy gets even more specific and splits the international allocation between developed international stocks and emerging market stocks, and the bond allocation between investment-grade bonds and high-yield bonds. The exact mix depends on the unique situation of the client and is often determined by a financial planning exercise.
The correct investment benchmark for your portfolio should reflect your investment policy. Let’s suppose your investment policy calls for you to invest 40% in U.S. stocks, 30% in international stocks, and 30% in investment-grade bonds. Your performance benchmark should be constructed with 40% in a U.S. stock index like the S&P 500, 30% in an international stock market index, and 30% in an investment-grade bond market index. This benchmark index will show you what your performance should be given the unique mix of your portfolio. Your investment advisor can help you construct and follow a portfolio benchmark that is appropriate for your investment policy.
Proper performance measurement goes well beyond defining the appropriate benchmark. In coming weeks, we will explore other metrics to help you understand how well your portfolio strategy is working.
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Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw.com.