"I have been struck by how important measurement is to improving the human condition," Bill Gates recently wrote. "You can achieve amazing progress if you set a clear goal and find a measure that will drive progress toward that goal ... This may seem pretty basic, but it is amazing to me how often it is not done and how hard it is to get right.
Investors track progress with a simple measure: The benchmark. We have standard stock benchmarks, like the S&P 500, that investors measure their returns against. If returns exceed the benchmark, you're succeeding. If not, you're failing.
Benchmarks are important, and this is how it should be. But a flaw often gets overlooked.
Benchmarks implicitly represent a normal rate of return of an average investor. They're presented as the equivalent of median household income, or average SAT scores.
But they're nothing close to that. The average investor, active or passive, doesn't earn a return anywhere near the benchmark.
Median incomes are based on real wages. Average people actually earned that money in real life. But investing benchmarks are hypothetical returns of what you could have earned in theory, even if hardly anyone actually does.
For an investor to earn the returns of the benchmark, they would have to own it continuously, for years on end, without touching shares and reinvesting all dividends. They'd have to sit patiently when markets plunged, never selling out of fear, never needing the cash to fund retirement or a house, and never paying an advisor for advice.
How many investors actually behave that way? Few. Nothing close to the average investor.
Take the Vanguard 500 fund. It's the closest thing we have to a tradable benchmark – an S&P 500 fund with a negligible fee.
The fund has an average annual return of 6.3% over the last 10 years. But the average investor in the Vanguard 500 fund earned 4.4% a year. The difference is due to money coming into the fund when the market is high and selling when it's low. (Morningstar tracks these figures).
So, here's a question: What's an appropriate benchmark? The hypothetical return of what someone could have earned in the S&P 500, or the actual return of what average people get when attempting to match the S&P 500?
I could argue it's the latter.
To stay with the Vanguard example, investors don't consider themselves successful unless they exceed the 6.3% annual return over the last decade. But in reality they'd be above average if they exceeded 4.4% a year. Someone who earned 5% a year over the last 10 years would be trailing the benchmark but still doing far better than most investors. We should cheer them, but we don't. We call them failures, even if they're top-tier and accomplished something their peers couldn't. It's a peculiar standard.
Benchmarks typically measure the performance of a money manager, most of whom have no control over when their investors buy or sell their funds. The traditional benchmark is still the most logical from that perspective.
But obsessing over benchmarks for all investors implicitly pretends that the emotional side of investing that isn't captured in a hypothetical returns doesn't matter. In reality, few things matter more.
An important part of measuring progress is knowing your alternatives. Every decision has to be weighed against its opportunity cost. Investors almost always assume a benchmark like the S&P 500 is the proper opportunity cost to measure their returns again. But that's probably wrong. It's based on an assumption that anyone can go out and earn benchmark returns tomorrow. In theory, they can. In reality, most investors don't have the temperament to match it even if they try.
Which is to say: When making investing decisions, we should spend more time asking, "Does this help improve my actual returns?" rather than, "Did I match or outperform a benchmark?" The former is the only one that measures real-world progress for most investors.
This isn't an excuse for underperforming funds. Most won't meet their objectives. It's a plea to focus more on becoming better investors, rather than anchoring to a benchmark that masks how difficult the emotional side of investing can be. We talk a lot about how difficult beating the market is, and we should. But it's just as hard – maybe harder – to match the market's returns.