Before I define what investing benchmarks are and why they are important, allow me to set the stage for today’s lesson. Those who know me well know that, in addition to being a finance fanatic, I am obsessed with beer and barbecue. Today, I’ll combine all three passions and share with you some recent experiments I performed while barbecuing with beer.
I promise there’s a money lesson in here, so stick with me!
BBQ’ing with Beer – An Analogy
In the first experiment, I cooked pork spare ribs. I marinated the ribs in beer and successively basted the ribs with the beer during the cooking (smoking) process.
Once the ribs were cooked, it was time for a verdict. Was barbecuing with beer a good idea? To answer that question, I used my wife as the taste tester.
What did she think? Were beer-basted ribs any good?
Yes! Fortunately for me, she enjoyed the beer-cooked ribs very much! Given the results, one could easily assume that barbecuing with beer is a smart idea. This is explained in the extremely scientific equation below:
bbq + beer = yum
However, I was not quite satisfied with that assumption. To add more context to my experiment, I tried another experiment.
The second time I barbecued with beer, I chose to smoke a second rack of pork ribs. But, this time I made two racks – one cooked with beer and one cooked without beer.
After I was done cooking, I could embark on a real comparison of the two tasty meats.
Fortunately, my wife was up for the challenge and helped herself to both styles of ribs. Soon after, the truth was born: she liked the ribs without beer better. How interesting! Thus, we can use the two following highly-scientific formulas to display the results of the second experiment:
bbq + beer = yum
bbq = a relatively larger amount of yum
The Importance of Comparisons
So, what happened? How did barbecuing with beer go from being a good idea to a relatively not-so-good idea?
The answer is obvious, but I will explain it anyway. In the first experiment, there wasn’t a comparison. Without a comparison, we had no idea how good the results truly were. Sure, barbecuing with beer was good. But, how can you know it’s best when you have nothing to compare it to?
Had I not made the second rack of ribs without beer as a comparison, I could have wrongly assumed that barbecuing with beer was the way to go. By making a comparison, on the other hand, I determined that beer was a fancy additive that didn’t enhance the taste.
According to the wife, I could skip the beer and still serve tasty ribs. At the end of the day, that’s good to know.
Now that I’ve hammered away at the importance of comparisons, let’s bring this conversation into the realm of investing.
Investing Without A Benchmark
Imagine you bought some shares of stock in Facebook, Tesla, Netflix, Google, or anything else fun and interesting. Over time, the price of your stock went up. Maybe you made a few hundred dollars. Maybe you made a few thousand. Either way, you’re pretty excited because you made some money. Good for you!
But, what’s your benchmark? What’s your point of comparison? What could you have done in the same amount of time? Was there a better alternative? Did you actually lose money compared to another, better investment?
How can you even answer the question? Enter the benchmark.
Use a Benchmark When You Invest
A benchmark in investing is your comparison. The benchmark tells you how much money you could have had were you to use the simple, plain-and-easy strategy. Maybe the simple plain-and-easy strategy will do better than your strategy of investing in Google, or Facebook, or Netflix. Then again, maybe not. Maybe you are a true investing genius, outperforming the benchmark.
The reality is, either could be the case: You could be a stock market whiz or you could be foregoing hundreds of thousands of dollars per year because you’re investing on a whim with no basis to compare your results to. But, you will never know unless you compare your own investment performance to the performance of an investing benchmark.
Which Investing Benchmark Should I Use?
Depending upon your particular style of investing – and your goals – the best benchmark to use can vary. There are benchmarks for stocks of companies in the United States (e.g. the S&P 500). There are benchmarks for stocks of companies in international countries, like MSCI EAFE. There are even benchmarks for junk bonds and benchmarks for commodities. Of course, you will have to pick the benchmark that makes the most sense for you given your particular investing strategy.
Use a Benchmark When You Invest
While adding something “extra” to the pot might seem like a good idea, that doesn’t mean it will enhance your outcome. And sometimes, the easiest strategy is the strategy that yields the best results. So, the next time you decide to invest in a stock or, maybe even a hedge fund, remember to compare your performance to a benchmark. That way, you’ll know how good your cooking really is.