Most investors probably agree that diversifying your stocks makes sense. That way, if a few holdings aren’t working out, they won’t sink your entire portfolio. But where do you begin? In Fisher Investments’ view, basing your portfolio on a diverse measure of the market lays the foundation for successful investing. The investment term for this is “benchmarking.” Selecting the right benchmark is one of the most important decisions an investor can make, in our view. Here we explain what makes a good stock benchmark—and how to use it once you have one.
A benchmark is a stock index. But not all of them are created equally, in our view. We think a benchmark index should have three main attributes:
1) A long history through several market cycles. An established performance history gives you an idea of a benchmark’s returns through good times and bad—i.e., both bull and bear markets. Now, this won’t tell you what the future holds—no backward look at history will. But, in Fisher Investments’ view, it can offer a reasonable guide to set long-term expectations.
2) A market-capitalization (market-cap) weighting. A market-cap-weighted index scales stocks according to their market cap—stock price multiplied by share count—which provides a sense of a company’s value. Larger market-cap firms will have greater influence on the index’s movement. We think market-cap-weighted indexes are more useful than price-weighted indexes (in which share price determines a company’s influence) because a stock’s price by itself doesn’t indicate a firm’s actual market value or really any useful measure of its importance.
3) A broad and diverse composition. A diversified benchmark that isn’t overly concentrated in any one sector, industry or company helps you avoid taking too much risk in a single market segment. If you go all in on any one area and it lags—or tanks—that could compromise your investment objectives. Using a broad benchmark as the basis for portfolio construction can mitigate this risk.
Fisher Investments believes a benchmark provides a practical roadmap to stock allocation. You may feel comfortable investing only in what you know (e.g., your home country or an industry you are familiar with), but that can severely limit your opportunities. For example, as big as America’s markets are, they comprise about two-thirds of the MSCI World Index—and ignoring one-third of global developed market cap leaves a blind spot, in our view. Similarly, Tech, at about a fifth of global market cap, is the world’s biggest sector—and US giants make up the vast majority of it. But then, around 80% of the world is outside of Tech. A broad and diverse benchmark shows you all the areas you can position your portfolio in—and provides guidelines on allocation sizes.
Benchmarking to a well-constructed stock index also provides a good basis for diversifying your portfolio because you can easily see how it differs from the market. If what you own is heavily skewed to a handful of sectors or individual companies—compared to your benchmark index—you may be subject to potential concentration risks. Without a benchmark, you might not even be aware of it. But a benchmark can reveal what risks you are taking in your portfolio and correct them if unwanted. You can also choose to adjust your allocations deliberately, using your benchmark as a basis for overweights or underweights.
A benchmark’s other core purpose: It can be a useful measuring stick for portfolio performance. The MSCI World Index rose 21.8% in 2021. If this was your benchmark and your portfolio’s performance was far out of line with that figure—either to the upside or downside—it may be improperly geared, perhaps requiring a re-evaluation of your portfolio’s allocation.
Fisher Investments also believes a benchmark can help set realistic return expectations and instill investment discipline when making portfolio decisions. Without one, there is a danger of measuring your personal performance against arbitrary or incomparable reference points—say, a basket of cryptocurrencies you saw on the news or your neighbor’s portfolio. Along with providing a better sense of how well (or poorly) your investment decisions impacted returns, benchmarking can help keep you grounded and on track to meet your own personal financial goals.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
Sources:
[i] Source: FactSet, as of 01/19/2022. MSCI World market cap by country, 01/18/2022.
[ii] Ibid. MSCI World market cap by sector, 01/18/2022.
[iii] Ibid. MSCI World Index return with net dividends, 12/31/2020–12/31/2021.