Everybody wants good returns. But how do you know if you are getting a good return?
All too frequently the only way that investors assess whether they’re getting a good return or not is whether the performance figures lie between what you can get on a one year term deposit at the bank and 10%. Conversely investors believe that if they get more than 10%, they must be facing an increased chance of suffering permanent loss – and so a return of greater than 10% may mean that they are doing the wrong thing.
Applying the above criteria is the best way I know, to miss out on the returns to which you are entitled because it has absolutely no connection back to that in which you are invested. For instance, if you are investing in
Using the underlying benchmark, then solves the following problem. Investors going into diversified portfolios know that some years they produce negative returns. But the question is, when you are presented with a negative return, how do you know that this is the year you should have got a negative return or, depending on the size of the negative return, how do you know that it is neither too small nor too large from what you should have been expecting? Both of these are answered by comparing against the appropriate benchmark.
Failing to follow benchmarks explains why investors never really see the underperformance of the stock picker and market timers because they are looking in the wrong place. If all you are doing is looking at the nominal return and looking for a figure between 7 and 10, you are never going to be comparing against the true benchmark to be able to see the true under- or over-performance.
Therefore the answer of what a good return is, a good return is a return which is on or above the benchmark. This is because you are taking the risk of being in that market, you should therefore expect to get the return of that market.
In this way a return which is positive 20% against a benchmark of positive 20% is of exactly the same benefit as a return of -4% against the benchmark
* CRSP data 1927-2014