SIMON BROWN: I’m chatting now with Jonathan Brummer: he’s an investment consultant at RisCura. Jonathan, I appreciate the early morning. Benchmarks – in many senses a really important part of the entire investment process, and they help us understand how we are doing; it’s less about the short term, more about the medium- to long term. The important point of the benchmark, though, is it really needs to fit the individual, to fit the risk requirements and the like. It is surely the key point to them.
JONATHAN BRUMMER: Morning, Simon. That’s indeed true. Like many things in life, investing is kind of a relative endeavour. So the thing that you are measuring against you need to choose carefully, and that’s got to match. Basically the outcome that you’re trying to achieve is a good starting point for that.
SIMON BROWN: I like that. Okay. So it’s focused on what you’re trying to achieve, and then [you] use the benchmark. And one of the popular ones is an inflation or perhaps an inflation-plus sort of benchmark. I see a lot of CPI plus 3%, CPI plus 4%, which I suppose fits into my outcome, but you say in the note that you put out that perhaps that’s not the best idea?
JONATHAN BRUMMER: Yes, I think it’s an important thing to discuss because it is I guess, such an accessible benchmark. It’s something that people understand. So if we start with inflation, we know [it] erodes the buying power of your money. You need to increase your investments by more than inflation, which means you’re growing your wealth. So up to this point it all makes sense.
But I would argue that inflation and beating inflation is more an investment objective, but isn’t that useful as a benchmark, especially over shorter periods. I could use a kind of method to explain that. If I’m planning a trip, I’m in Joburg, I want to drive down to Cape Town. Let’s say it’s 1 400 kilometres. I’m going to do an average of a 100 km/h, and that’s going to take me 14 hours. I might choose my benchmark as that 100 km/h.
The reality is during the trip I’m going to have zones where I’m doing 60 km/h, and zones where I’m doing 120 km/h. I’m going to stop to refill with fuel and buy a pie and whatever it is along the way. And so that average 100 km/h isn’t a useful benchmark.
I think CPI is similar in the sense that CPI moves quite slowly. It changes, let’s say, between 3% and 6%, but in investment markets your return can be much more volatile; it can be up by 20%, down by 20%.
And so when you’re comparing to that CPI-plus, especially over shorter periods – and short could be even five years – it’s not going to be that useful. You’re not going to know whether you are on track or not. So [that is] one of, I guess, the downsides, the failings of CPI-plus as a benchmark, although [for] an investment outcome it’s useful over a long period. The benchmark [is] not that useful over short periods.
SIMON BROWN: I like that, and I like the analogy. It makes sense. I’ve often looked at it and I’m thinking in 2022 your offshore portfolio is 100 miles away from CPI. But you shouldn’t be panicking because this is what markets do sometimes. That then brings [us] to the question of what sort of types of benchmarks are used in industry that are worth considering for listeners?
JONATHAN BRUMMER: I think there are two others that I’ve mentioned.
The one you’ll find is what’s called a ‘peer-relative benchmark’. I don’t think this is a great benchmark because it’s kind of keeping up with the Joneses.
It’s saying ‘I want to do at least as well as someone out there’. That’s the problem. Defining who that someone is, is very hard. And really what does it matter? Because you need to be focused on your own goals, not someone else’s. So again it is a benchmark that’s out there. I’d say just be careful.
…how you construct a useful benchmark is really to look at the underlying building blocks, and those are the asset classes that you invest in. So if we go back to ‘I want to achieve a CPI plus something’ – let’s say it’s about this 5% target – you now need to work it back and say to do that I need a particular asset allocation. So, quite simply, if you invest all in cash, it’s highly unlikely you will achieve that, which means you’re going to be adding some risk assets, equities as an example.
Once you know the mix of those asset classes you have, we can use [it] a proxy for that asset class. There are indices that are created to represent that asset class, and you use that as your benchmark. That’s similar to saying, if we go back to our analogy of saying, well, for the first five kilometres of my journey I’ll be in a 60 km/h zone, so I’m going to use 60 km/h as my benchmark during that period. Then when I get on the highway I want to stick to 120 km/h, etc.
So it’s a better, I guess, relative position to measure against, and the good thing is if I achieve reasonable returns relative to those over the short term, I will get to my CPI-plus-5% over the long term. So a good benchmark, I think, starts with ‘what is your outcome?’ Then pick the asset classes and the mix that’ll get you there, and then use those asset classes as the benchmarks. That’s going to work actually over a very short period – over one month, one year, it will work.
SIMON BROWN: What I like about that is it almost constrains you in a sense in terms of going too far out on a limb in terms of risk. When you know what your outcome is and you know what you’re trying to achieve over your investment lifetime, now suddenly you realise, ‘Okay, this is what I’m going to need. Let me build my benchmark around it. I don’t need to go and buy the crazy risk assets on the far left field’.
JONATHAN BRUMMER: Yes, exactly. Again, if we go to our metaphor, you’ll know that when you’re on the highway, 120 km/h is right. Even if you’re behind your average benchmark, you know you’re going to catch up. But you’re also not trying to go 140 km/h. As you say, you’re not trying to increase risk to catch up because you know over time you will catch up. I think it also helps with expectation setting.
So, as an investor, if my investment is down 5% in a one-year period, does that mean I should panic? Does that mean I’ve done something wrong, or I should change something? If I’m measuring it relative to a CPI-plus, which is clearly going to be a positive number, I might make a wrong decision.
But if I can measure it relative to a mix of asset classes and I understand that equities were down in this particular period, although it’s not a great feeling, it gives a sense of comfort that my plan is still on track. This is normal behaviour.
SIMON BROWN: I like that – ‘expectation setting’. I’d never thought of that. That’s what your benchmark does perhaps more than anything. Of course it’s tied to your outcome, but I like that.
We’ll leave it there. That was Jonathan Brummer, an investment consultant at RisCura. Jonathan, I appreciate the early morning.
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