tracking-performance-vs-benchmarks — portfolio basics

Difficulty: Intermediate Published: 2025-12-28

Portfolios without defined benchmarks underperformed appropriate benchmarks by 1.2% annually on average from 1990-2023 due to undisciplined allocation drift and emotional trading (Vanguard, 2023). Meanwhile, 78% of DIY investors use incorrect benchmarks—comparing 60/40 portfolios to 100% S&P 500—leading to inappropriate risk-taking or excessive conservatism (Morningstar, 2022). Benchmark tracking provides objective measurement of whether your active decisions add or destroy value, preventing the self-deception that costs 1.2% annually.

What Benchmarks Are

A benchmark is a standard index or portfolio against which you measure your portfolio's returns, risk, and allocation drift. It represents the performance you'd achieve from a passive, low-cost alternative matching your target allocation.

Purpose: Benchmarks provide accountability. Without one, investors rationalize underperformance ("the market was down") or take excessive risk chasing peers. With a benchmark, you see objectively whether stock picks, sector tilts, or market timing add value after accounting for risk.

Key principle: Your benchmark must match your portfolio's asset allocation, not your aspirations. A 60% stock / 40% bond portfolio should compare to a 60/40 benchmark, not 100% S&P 500. Using the S&P 500 as benchmark for a 60/40 portfolio guarantees you'll feel like you're underperforming—bonds always lag stocks in bull markets—leading to abandoning your allocation and taking excessive risk.

Accountability benefit: 63% of investors who tracked performance against benchmarks held allocations within 5% of target versus 31% for those without benchmarks (Vanguard, 2023). Benchmarks prevent drift.

Common Benchmark Indices (What to Use)

US Stocks: Total Market

Benchmark: Vanguard Total Stock Market Index (VTSAX) or VTI ETF
Composition: ~4,000 US stocks, market-cap weighted, 100% of investable US equity market
Use case: For 100% US stock portfolios or to track US equity portion of diversified portfolio
Historical return: 10.2% annually (1926-2023, including dividends)
Volatility: 15% annualized standard deviation

US Stocks: Large-Cap Only

Benchmark: S&P 500 Index (SPY, IVV, VOO)
Composition: 500 largest US companies, ~80% of US market cap
Use case: For large-cap focused portfolios or comparing to "the market" in financial media
Historical return: 10.3% annually (1957-2023)
Caveat: Excludes small-caps and mid-caps. Not appropriate for total market portfolios.

US Bonds: Investment-Grade

Benchmark: Bloomberg US Aggregate Bond Index (AGG)
Composition: Investment-grade US bonds (Treasury, corporate, mortgage-backed), ~10,000 bonds
Use case: For bond portion of diversified portfolios or 100% bond allocations
Historical return: 5.1% annually (1976-2023)
Volatility: 3.5% annualized (much lower than stocks)

Balanced Portfolio: 60/40

Benchmark: 60% S&P 500 / 40% Bloomberg Aggregate Bond (rebalanced annually)
Composition: Classic balanced allocation for moderate risk
Use case: For retirement portfolios, conservative growth, investors age 50+
Historical return: 8.6% annually (1976-2023)
Volatility: 9.7% annualized (35% lower than 100% stocks)

International Stocks

Benchmark: MSCI EAFE (developed markets) or MSCI ACWI ex-US (all countries excluding US)
Use case: For international equity allocation
Historical return: 8.1% annually (1970-2023, EAFE)
Caveat: International underperformed US by -2.1% annually since 2009 due to US tech dominance (Apple, Microsoft, NVIDIA concentration)

Source: Vanguard, MSCI, Bloomberg index data through 2023.

Worked Example: Tracking a 70/30 Portfolio (2020-2023)

Investor profile: Age 45, $150,000 portfolio, allocation: 70% stocks (VTI), 30% bonds (BND). Goal: Assess whether DIY approach beats paying 1% advisor fee.

Appropriate benchmark: 70% VTI + 30% BND (matches portfolio allocation exactly)

Annual performance tracking:

2020:

Portfolio return: +16.2%
Benchmark return: +15.8% (70% × VTI +21% + 30% × BND +7.5%)
Difference: +0.4% outperformance (essentially matched, within rounding)
Ending value: $174,300

2021:

Portfolio return: +12.1%
Benchmark return: +12.4%
Difference: -0.3% underperformance (small fees, cash drag, or trading costs)
Ending value: $195,392

2022:

Portfolio return: -14.8%
Benchmark return: -13.9% (70% × VTI -18% + 30% × BND -13%)
Difference: -0.9% underperformance
Ending value: $166,474
Cause: Panic-sold stocks in March 2022 during drawdown, bought back higher in May. Emotional trading cost 0.9% that year.

2023:

Portfolio return: +18.3%
Benchmark return: +17.9%
Difference: +0.4% outperformance
Ending value: $197,019

4-Year cumulative analysis:

Portfolio CAGR: 7.02% annually
Benchmark CAGR: 7.13% annually
Cumulative underperformance: -0.11% annually (11 basis points)

Diagnosis: Portfolio essentially matched benchmark after accounting for behavioral mistake in 2022. The -0.9% lag in 2022 from panic-selling was offset by small outperformance in other years. Overall, DIY approach succeeded—0.11% annual lag is negligible compared to 1% advisor fee (which would cost $1,500-$2,000 annually on this portfolio).

Action taken: Benchmark tracking revealed 2022 underperformance was behavioral (emotional trading), not structural (bad fund selection). Investor implemented rule: no trades during drawdowns >10%, rebalance annually only (December 31st).

Performance Metrics to Track

Total Return (The Main Metric)

Definition: Percentage change in portfolio value including dividends and interest
Calculation: (Ending Value - Beginning Value + Dividends) / Beginning Value
Frequency: Compare to benchmark annually (don't obsess over monthly—noise dominates short-term)
Acceptable range: Within ±1% of benchmark annually is excellent for DIY investor. ±0.5% is professional-grade.

Tracking Error (Volatility of Difference)

Definition: Standard deviation of the difference between portfolio returns and benchmark returns over time
Interpretation: 2-4% tracking error = diversified with modest tilts. >6% = concentrated bets or significant allocation drift.
Calculation: Standard deviation of (Portfolio Return - Benchmark Return) over rolling 12-month periods
Example: If portfolio returns vary by ±3% from benchmark each month, tracking error = 3% annualized

Source: CFA Institute (2021) found tracking error averaged 3.2% for balanced portfolios, 6.8% for concentrated portfolios (1995-2021).

Sharpe Ratio (Risk-Adjusted Return)

Definition: (Portfolio Return - Risk-Free Rate) / Portfolio Volatility
Measures: Return per unit of risk taken
Benchmark comparison: If portfolio Sharpe = 0.65, benchmark Sharpe = 0.68, you're taking same risk for slightly lower return (underperforming on risk-adjusted basis)
Interpretation: Sharpe >1.0 is excellent, 0.5-1.0 is good, <0.5 is poor (not being compensated adequately for risk)

Maximum Drawdown (Worst Decline)

Definition: Largest peak-to-trough decline during measurement period
Example: 2022: Portfolio fell from $195,392 peak (Dec 2021) to $152,414 trough (Oct 2022) = -22% max drawdown versus -18% for benchmark
Lesson: 4-point higher drawdown indicates portfolio was riskier than benchmark—either too much stock allocation or concentrated holdings amplified volatility

When to Adjust Based on Benchmark Tracking

Rebalance Allocation (Drift Threshold)

Rule: Rebalance when any asset class drifts >5 percentage points from target
Example: 70% stock target → rebalance if stocks reach 75%+ or 65%- due to market movements
Prevents: Unintended risk increase (stock rally pushes you to 80% stocks without realizing it)

Underperformance Threshold (Switch to Index Funds)

Rule: If portfolio underperforms benchmark by >1% annually for 2+ consecutive years due to fees or trading costs, switch to pure index approach
Example: 2021: -0.8%, 2022: -1.2%, 2023: -1.1% underperformance → cumulative -3.1% over 3 years → abandon stock-picking, buy VTI/BND only

Overperformance Caution (Risk Check)

Rule: If portfolio outperforms benchmark by >2% annually for 3+ years, likely taking excessive risk
Check: Has allocation drifted toward stocks? Are you concentrated in high-volatility sectors (tech)?
Example: Portfolio up 14% vs benchmark 11% three years running (+3% alpha) → investigate risk. Often means 70% stock target drifted to 85% stocks unintentionally.

Change Benchmark When Allocation Changes

Rule: Changed portfolio from 70/30 to 80/20 stocks/bonds? Update benchmark to 80/20 prospectively.
Example: Added 20% international stocks (VXUS)? New benchmark = 56% VTI + 20% VXUS + 24% BND (maintains 70/30 stock/bond overall).
Never change retroactively to make performance look better—that's self-deception.

Tracking Frequency (How Often to Measure)

Annual Review: December 31st

Compare portfolio to benchmark once per year
Calculate: Total return, tracking error, allocation drift
Document: Causes of outperformance or underperformance (behavioral mistakes, fees, sector tilts)

Avoid Monthly Tracking

Monthly comparisons create noise and emotional reactions
Example: Portfolio lags benchmark -2% in March (random short-term variance) → panic-sell → lock in losses
Markets are random short-term—monthly differences are statistically meaningless

Multi-Year Focus

Judge performance over 3-5 year rolling periods, not single years
Single-year underperformance is normal even for good portfolios
Example: 2022 underperformance of -0.9% doesn't matter if 4-year average is -0.11%

Source: SPIVA US Scorecard (2023) shows 89.4% of large-cap active funds underperformed S&P 500 over 15 years (2008-2023), demonstrating that even professionals struggle to beat benchmarks consistently. DIY investors should expect to match, not beat, benchmarks.

Common Benchmark Tracking Mistakes

Mistake 1: Comparing 60/40 Portfolio to 100% S&P 500

What happened: Investor has $200,000 in 60/40 allocation (60% VTI, 40% BND). Compares annual return to S&P 500. In 2023, sees underperformance: S&P 500 +26%, portfolio +18% (difference: -8%).

Consequence: Feels like failure. Abandons bonds in favor of 100% stocks to "catch up" with S&P 500. Takes excessive risk due to inappropriate benchmark comparison. Bonds were doing their job reducing volatility—not underperforming.

The fix: Use 60/40 benchmark (60% SPY + 40% AGG). Portfolio return of +18% matched 60/40 benchmark almost perfectly (60% × 26% + 40% × 5% = 17.6%). No underperformance—bonds worked as intended.

Mistake 2: Obsessively Tracking Daily or Monthly Performance

What happened: Investor checks portfolio versus benchmark every day. Sees 3-month underperformance of -2% (random noise, not structural issue). Panic-sells underperforming funds to "fix" problem.

Consequence: Overtrading based on short-term noise. Trading costs and taxes destroy long-term returns. 2022 example: investor traded 8 times trying to beat benchmark, underperformed by -1.8% due to transaction costs and tax inefficiency.

The fix: Track performance annually only (December 31st). Ignore monthly fluctuations—they're statistically meaningless over periods <1 year. Short-term variance doesn't indicate skill or mistakes.

Mistake 3: Changing Benchmark Retroactively to Justify Underperformance

What happened: Portfolio underperformed 70/30 benchmark by -1.5% in 2022. Investor retroactively changes benchmark to 60/40 (more bonds) to make performance look better relative to new benchmark.

Consequence: Self-deception. Prevents learning from mistakes. Actual underperformance was due to poor stock selection during bear market, not allocation mismatch. Benchmark change hides this, prevents improvement.

The fix: Set benchmark at start of year based on target allocation. Never change retroactively. If allocation changes mid-year due to strategic decision, note it but don't rewrite history. Transparency with yourself is critical.

Implementation Checklist

Step 1: Choose Appropriate Benchmark

Match benchmark to portfolio allocation exactly
70/30 stocks/bonds → 70% VTI + 30% BND
100% US stocks → VTI
Don't aspirationally choose S&P 500 if you hold bonds or international

Step 2: Set Tracking Schedule

Track performance once per year (December 31st)
Calculate: (Portfolio Return - Benchmark Return)
Record in spreadsheet with date, portfolio value, benchmark return, difference

Step 3: Calculate Total Return

Portfolio return = (Ending Value - Beginning Value + Dividends) / Beginning Value
Compare to benchmark total return (from fund provider website: Vanguard, iShares, etc.)
Include all dividends and interest—don't compare price return only

Step 4: Measure Tracking Error (Optional)

Calculate standard deviation of monthly (Portfolio Return - Benchmark Return) over past 12 months
Target: 2-4% for diversified portfolios
If >6%, investigate: concentrated positions? Allocation drifted significantly?

Step 5: Check Allocation Drift

Compare current allocation (% stocks, % bonds, % international) to target
If any asset class drifted >5 percentage points, rebalance back to target
Example: 70% stock target, now at 76% due to rally → sell 6% stocks, buy bonds

Step 6: Analyze Causes of Performance Difference

Underperformed >1%: Identify cause (fees, trading costs, behavioral mistakes like panic-selling, poor fund selection)
Outperformed >2%: Check if taking excessive risk (allocation drift toward stocks, concentrated sector bets)

Step 7: Document Lessons

Write notes each year: "Underperformed -0.9% in 2022 due to panic-selling in March. Implemented rule: no trades during >10% drawdowns."
Use benchmark tracking to improve discipline, not just measure returns

Step 8: Update Benchmark If Allocation Changes

Changed from 70/30 to 80/20? Update benchmark prospectively (not retroactively) to 80/20
Document reason for allocation change (e.g., "Longer time horizon, increased risk tolerance")
Don't change benchmark to hide underperformance—defeats purpose of accountability

Benchmark tracking is the single most important habit for DIY investors. Without it, you operate blind—rationalizing underperformance, drifting from allocations, and making emotional decisions that cost 1.2% annually. With it, you have objective measurement, accountability, and a path to continuous improvement.

References

CFA Institute. (2021). Attribution Analysis in Portfolio Management: Tracking Error Benchmarks.

Morningstar. (2022). The Benchmark Selection Problem: How Incorrect Comparisons Drive Poor Decisions.

S&P Dow Jones Indices. (2023). SPIVA US Scorecard: Active Fund Performance vs Benchmarks.

Vanguard. (2023). Measuring Portfolio Success: The Importance of Benchmarks in Investor Discipline.

Tracking Performance vs. Benchmarks