Follow-up on Benchmarks

In the 4Q12 Quarterly Perspective I wrote that benchmarks can be misleading.  I referred to the performance of the Dow Jones Industrial Average specifically, because its methodology tends to produce results that for better or worse do not reflect the experience of the average stock investor.  This past quarter (1Q12) the Dow understated the markets’ strength with a gain of only 8.8% while the S&P 500 rose 12.6%.  To be honest, that’s a minor issue.  We have largely solved it for most investors by using blended benchmarks, because they take into account that most portfolios have at least three components to them – a bond portion, a domestic stock portion and an international stock portion.  A blended benchmark paints a different picture than just looking at one component.  Let’s take a fairly aggressive portfolio, say a “7” or 70/30 stock/bond split, last year.  The Barclays Aggregate Bond Index gained 7.84% in 2011.  That probably overstates the average bond fund, but we’ll use it anyway.  So what should we use for the 70% that is in stocks?  The S&P 500 gained 2.11% in 2011, but that’s just the largest 500 stocks.  Small stocks actually lost -4.18% last year.[i] International stocks lost a whopping -12.14% in 2011[ii].  So what kind of return should investors have expected?  What if you assume the portfolio would hold some cash for liquidity purposes?  As you can see, what benchmark you use and how you weight them makes a huge difference.