Apples to Apples

Thank you to those that have participated in the Poll titled “How Would You Rate Dane County and The Greater Madison Economic Situation”.  If you haven’t participated in it yet, be sure to check it out in the last post dated October 4th.  We will keep the poll up for another week or so and then post the results along with some commentary. 

Today however, let’s discuss the idea of benchmarking and indexes.  No doubt you’ve seen headlines reporting that a particular index is up or down.  The first reaction some investors have when seeing these headlines highlighting particular indexes is that their portfolio should have gone in the same direction and to the same degree.  For example, if the S&P 500 was down 1.3%, well then my portfolio was down 1.3%.  That’s not necessarily the case, let me explain why.

An index is simply a way to measure and report the fluctuations of a securities market or a particular segment of a market.  If your portfolio is allocated in a way that represents the exact positions in the index, then yes, your portfolio should be highly correlated with the index.

Most investors however, have a broad target allocation representing a certain portion of their portfolio that should be allocated using the following asset categories:

  1. Equity or ownership positions
  2. Fixed income positions
  3. Cash or cash equivalents.

An illustration of this would be 75/20/5, indicating 75% of the portfolio is reserved for equity positions, 20% is for fixed, and 5% is a reserve of cash equivalents.

Using this makeup of 75/20/5, a good benchmark for the broad target allocation would be 75% of an equity index (possibly the S&P500); 20% of a fixed income index (Barclay Capital Global Aggregate Bond Index is a good choice); and then a good benchmark for cash (the 90 day T-bill) would illustrate the performance of the market.  Now you can more accurately determine how your portfolio is performing relative to expectations.

Aside from the broad target allocation, in order to obtain a more precise benchmark for your portfolio, it may be necessary to breakdown your positions a bit further.  For example, how much of your equity position is allocated to large cap securities, mid cap securities, and small cap securities?  What are the terms on your fixed income instruments?  What proportionate amount is long term, intermediate, and short term.

By selecting the appropriate indexes and proportionately allocating them based on your portfolio’s makeup, you may get a better idea of how well your portfolio is being managed now that you are comparing apples to apples.


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