How do you know if an investment you have made is doing well or not? How can you tell if it’s worth paying an investment manager rather than just buying an index fund? Is 8% per year a good return?
The simple answer to each of these questions is, it depends what you compare it to. You need to have something meaningful to measure an investment against in order to gauge how it is doing. This is known as benchmarking. Whether you realise it or not, you are probably already familiar with some benchmarks:
- MSCI Global Index – covers global stocks
- S&P 500 – covers US stocks
- FTSE 100 – covers UK stocks
- Nikkei 225 – covers Japan stocks
- Citi World Government Bond Index – covers global bonds
So a mutual fund manager running a US Growth Stock fund might be benchmarked to the S&P 500 index. If he is underperforming the index, he is not worth paying fees to. If he is outperforming the index his fund will be popular. If he is getting a wildly different result to the index then he is doing something very strange and likely won’t keep his job for long!
So is 8% a good return? Well it partly depends on what your expectations are. The S&P 500 has returned, on average, 7.1% per year over the last 10 years, so 8% seems like a pretty good return. However, if your goal was to be aggressive and get a 20% return you might still be disappointed. In 2008 the S&P 500 fell by 37%. Even a 1% return that year would be nothing short of exceptional!
So how should the average investor benchmark their investments? I would say the basic minimum benchmark should be inflation in your base currency. Inflation is defined as the rise in the cost of goods and services over time, and is the reason we don’t just lock our money in a safe. Take a look at the table below showing the effect of inflation on $100:
We are currently living in a low-inflation environment, particularly if you live in Japan. However, if you look at the historical average, 3% is a good guide. So at 3% inflation, if you put your $100 under the mattress for 20 years you will still have $100, but it will only buy you $54.38 in goods and services. The spending power of your money has almost halved!
One thing I will stress here is that we are talking about inflation in your base currency. If you are living in Japan, but you are planning to retire in Australia, for example, don’t be fooled by the low inflation rate in Japan. Back home the current rate of inflation is 2.1% and rising. Keeping money in your Japanese bank account is not only a currency risk, but you are losing 2.1% per year in spending power!