What is your performance benchmark and why did you choose it as a model of comparison? If you are like most individual investors, your investment mix does not look like an index, such as the Dow Jones Industrial Average, the S&P 500, or the NASDAQ; nor does your investment strategy match that of a hedge fund or a mutual fund. So why would you care if you are outperforming or underperforming the conventional benchmarks?

Absolute returns, relative returns, or somewhere in between?
It is likely that your investment objectives and underlying strategies are not like hedge funds or mutual funds, but rather something in between. For example, most hedge funds employ an absolute return strategy, which is to say they strive to achieve a positive return by using a range of investing techniques, from long positions to short-selling, options, leveraged assets, and arbitrage. And mutual funds -- the actively managed ones at least -- typically employ a relative return strategy, which means they seek to outperform a certain benchmark index or the average returns of their respective category peers.

If you are wise, you will have elements of both strategies but will not mimic either; you will seek returns that are both achievable and necessary to accomplish your investment goals. For example, you may need an average return of 7% to reach your long-term goals, but you will not expect or aim to earn this precise return each year, like the absolute-return strategy; nor will you expect or aim to outperform a broad market index, as does the relative-return strategy.

Setting reasonable expectations
Instead, as I suggested in a recent article, you build a portfolio that is expected to have both good years and bad years but can achieve the average annualized returns required to achieve your goals. So when you are comparing your portfolio to a benchmark, you may be undermining your goals by placing false expectations on your returns; you are comparing apples to oranges.

For the same reason your portfolio may have underperformed the S&P 500 in 2013, you may be outperforming the S&P 500 in 2014. Consider a simple portfolio that consists of two exchange-traded funds: SPDR S&P 500 (NYSEMKT:SPY) and Vanguard Total Bond Market ETF (NYSEMKT:BND). In 2013, the stock ETF had a total return of 32.3%, while the bond ETF lost 2.3%.

So far this year, the SPDR S&P 500 is up a meager 0.7%, whereas the Vanguard Total Bond Market ETF is up 1.3%. Therefore, with your balanced portfolio, you would expect to perform somewhere between those two holdings (below stocks and above bonds in 2013 but above stocks and below bonds in 2014).

How and why to create your own benchmark
Therefore the fundamental reason to ignore conventional benchmarks is to set reasonable expectations, which is the same reason to create your own benchmark. You can do this by multiplying the allocations for stocks and bonds by their respective relative indexes:

(allocation to stocks x total return for stock benchmark) + (allocation to bonds x total return for bond benchmark) = customized benchmark target return

For a simplified example, say your portfolio consists of 70% SPDR S&P 500 and 30% Vanguard Total Bond Market ETF, and for a given time period, the stock ETF is up 10% and the BarCap is up 5%:

(0.7 x 0.1) + (0.3 x 0.05) = 0.085

The result is a total return of 8.5% -- though you'd earn slightly less than that after fund expenses.

Note: Keep in mind that this example assumes that the allocation percentages began the given period at those exact amounts. For example, if you begin a calendar year at your target percentages and never rebalance your portfolio, those allocations will likely be different when you begin the next calendar year due to natural market fluctuations.

So the wisdom of ignoring conventional benchmarks and of creating your own benchmark is twofold: It is to set reasonable expectations but also to prevent poor investing behavior. If your portfolio does not outperform the S&P 500, for example, you will not be discouraged or tempted to change your strategy or holdings. In contrast, you will not tell yourself you are a genius when you outperform stocks during a bear market for stocks.

Kent Thune has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.