It may not seem like it but this man may unwittingly hold the secret to understanding how you measure your investment portfolio…but looks can be deceiving.

His name is Oliver Smoot, he is the former Chairman of the American National Standards Institute, (more recognized by its acronym ANSI) which as you might guess, is all about measurement and standards. This may turn out that this is slightly ironic for reasons we will explore. (FYI--the woman out of the frame, whose hand is sticking into the picture is measuring his ear, which will also make sense in a bit.)

Everybody in the investment world seems obsessed with benchmarks. Investment advisors, money managers, clients and regulators all spend an inordinate amount of time on the issue of benchmarks. There are good and “not-so-good” aspects to this fixation. In preparation of an article on good and bad aspects of benchmarking, I thought it would be a good idea to pause and actually define what these “benchmark” things are, and talk about where they come from.

First, what is a benchmark, and where does the term come from?

Well this isn’t some kind of heavy-duty ultra-serious research piece, so we’ll just go with the easy answers to this. First, the principal definition for a benchmark, according to Webster’s Dictionary Online, is the following:

Full Definition of benchmark

1.  usually bench mark :  a mark on a permanent object indicating elevation and serving as a reference in topographic surveys and tidal observations

2.  a: a point of reference from which measurements may be made.  b:something that serves as a standard by which others may be measured or judged. c: a standardized problem or test that serves as a basis for evaluation or comparison (as of computer system performance)

   (http://www.merriam-webster.com/dictionary/benchmark)

The term bench mark, or benchmark, originates from the chiseled horizontal marks that surveyors made in stone structures, into which an angle-iron could be placed to form a "bench" for a leveling rod, thus ensuring that a leveling rod could be accurately repositioned in the same place in the future. These marks were usually indicated with a chiseled arrow below the horizontal line.( https://en.wikipedia.org/wiki/Benchmark_%28surveying%29)

In the event that you are part of the majority of the population who have no idea what a leveling rod it, it is basically a big measuring stick that surveyors use to measure heights. This little mark cut into a building allowed somebody to come back and make sure the building was level, so it didn’t fall over and kill people, presumably. We have come a long way with the concept since then.

So what makes an investment benchmark?

For an investment benchmark, we need to look to definition 2b above, “something that serves as a standard by which others may be measured or judged.”   (I bet Oliver Smoot likes this particular definition best). In the case of investment benchmarks, the investment industry, and in some cases the regulators of the industry have set forth guidelines on how you should measure your investments. Typically it involves comparing your performance to some other arbitrary instrument or measure. An example of this is comparing your investments to the performance of an “index.” A commonly known index (for example) is the list of stocks that have been published as the “Dow Jones Industrial Average”¹ since 1896. Some day we might do a brief history of the Dow Industrials, but the short version is that it was created by Charles Dow, who was (I think) the editor of the Wall Street Journal at the time. It consists of thirty stocks, and the stocks are weighted in such a manner that the ones with the highest price are weighted more heavily. The actual calculations and creation of the index are not particularly important, but suffice it to say that the index serves the particular purpose of giving people a reference to compare to. The stocks are selected with the idea that they are representative of the US. Economy as a whole. The theory is that the index allows investors to compare their personal results to the results of this index and get a sense of their relative luck or relative skill at picking stocks. An index doesn’t represent an actual investment in the stocks, instead it is simply a mathematical construction, and is provided to create a measuring stick. There are loads of other common indexes which are used as benchmarks for comparison, but that isn’t important right now. We want to pause and think about what is taken for granted.

An often overlooked consideration in benchmarking.

One word that most people reading this would skip right by in the previous paragraph is the word “arbitrary.” It so happens that this word is pivotal to the understanding of benchmarking.   All benchmarks are fundamentally arbitrary, even if everybody agrees to use them. When Dow Jones was acquired, it became part of publishing giant McGraw-Hill. Basically, some people at McGraw Hill now decide what the components of the DJIA are in some subtle ways, control the public perception of market performance. If one (or several) of the thirty companies that comprise the Dow were to fall on hard times, because of mismanagement, people around the country would think the stock market wasn’t faring all that well, potentially, because the results of those losers would affect the average overall. It would potentially make investors whose portfolio did well think they were great stock pickers, if they did better than the Dow in that year.   But really, what does beating the Dow mean in any practical sense? Nothing at all, really. It is an arbitrary benchmark, as are all indexes. In a future article we will be talking about choosing a measurement that means something to you. For now, let’s just agree that any measurement comparing against arbitrary benchmarks needs to be examined. The measurement you choose should measure what you are trying to accomplish. If your intention is to perform as well or better than the Dow Jones Industrial Average, then certainly it makes sense to measure against it. But then you would need to ask why you chose that specific goal.

My point is that many well thought-out measurement criteria can work just as well, if applied with appropriate discipline. How about something more tangible, such as measuring your absolute progress toward some fixed goal? If your goal is to save a hundred thousand dollars, and the account you have dedicated to that objective gets three percent closer to it this year, well…that seems pretty straightforward, it is a personal benchmark, and it is a very simple one. It isn’t done yet, because there are more decisions to make, but that is the subject of our next article, so, you have to wait, or think it over yourself.

In the rush to show off ever more sophisticated statistical tools for the measurement of portfolio performance and behavior, we run the risk of losing sight of the most basic measurements of progress, and losing the forest for the trees. Why would you adhere to an arbitrary and largely irrelevant benchmark, in favor of a more meaningful one for yourself?

If you want a good example of arbitrary benchmarking, you should get to know the somewhat obscure unit of measurement known as the Smoot. The story goes that in 1958 a bunch of MIT frat brothers performed a prank, in which they basically flipped their shortest pledge (Oliver Smoot) end for end across the Harvard Bridge between Boston and Cambridge, painting a mark on the bridge for each ten body lengths. Each one of the body lengths was dubbed a “Smoot” and the bridge was marked as 364.4 Smoots _+/- an ear. Do you remember the ear measurement gag in the picture, which was taken like forty years later? (Yes, I know what you’re thinking. Those MIT guys…what will they think of next? Just whacky. If this story seems ridiculous, and you don’t believe me, check out the Wikipedia page on Smoots here.) The Smoot is a pretty imprecise measurement, but it totally worked for them, which is to say it served a specific purpose. The story seems to be that the President of the frat wanted easy marks on the bridge, so he would know far he had come, and how far still to go when walking to class. The bridge isn’t terribly long, but evidently it was long enough that in bad weather you were wishing it was shorter…and as it happens, the Smoots were just fine for the purpose. You could look at the bridge and see that you had just passed the 150 Smoot mark…almost half way across. They could have just as easily marked it in any other way.

The Smoots have become something of a local landmark and have been kept up since 1958, so if you walk that bridge, you will still find them there. As for Oliver Smoot, It is slightly ironic that this potential icon for personalized measurement became the Chairman of an organization devoted to standardizing measurements. Our world is vastly complex, and our measurement systems (including those we use for investments) are increasingly sophisticated. But let’s start by thinking about the most relevant personal measurements, and then worry about how we apply standardized measurements to the mix. Before we can do that appropriately, investors need to have a clear idea about what we are trying to measure, which is a question too seldom asked, in my humble opinion. If the measurement precedes the decisions about goals and what is appropriate to measure, we can have unintended consequences.   For example, if everyone spends time and effort beating some particular index, they can drift into a positioning that exposes them to more absolute loss than they might want.   For the relative possible out-performance on a year to year basis, they might experience an absolute point-to-point loss which might be unsatisfactory.   Did beating the Dow Jones industrial average by one percent really make a difference in 2008, if you were down a half million dollars? Maybe yes, maybe no. It all depends on many other factors. This is the nuance that is often ignored. Short term measurement decisions color how investors perceive the amount of risk they carry, and it can lead to decisions in response to short term measurements which create or exacerbate losses. We will have more to say on this down the road, but for now, lets say that it is not uncommon for investors to sell winners and keep losers, because they lock in gains, and feel good about them, but hate to divest of losers, because they hate being wrong. Add this to the feature that we are cognitively programmed to consider recent results or occurences more heavily than ones further in the past, and you have a recipe for disaster. Short term benchmark measurement can lead to decision making distortions, and over time…unfavorable results.

As we look further into investor behavior and investor perceptions about risk, we will need to evaluate measurements and how they affect those perceptions, which we pick up in the next article in the series. Stay tuned. The simple, inevitable, and often ignored questions are coming up next.