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A benchmark error is the use of an inappropriate reference when assessing portfolio performance. This can result in inaccurate calculations. They may overstate the performance of an investment portfolio, creating a sense of false confidence, or they could understate it, leading an investor to change strategies when this actually wasn’t necessary. Such errors can create serious problems for investors and may be an especially large problem for portfolio managers, who must exercise due diligence in their assessment of portfolio performance to prevent issues like this.
Investors use benchmarks as standards to gauge their portfolio performance. It’s important to select an appropriate one. A person with heavy investments in European commodities, for example, shouldn’t be using the Nikkei as a benchmark, because performance in the Japanese market isn’t directly tied to European commodities. Instead, that investor would want to use an investment index tied to European commodities, because the investor’s portfolio should perform at or above the returns on the index.
The mixture of assets in a portfolio can create significant a benchmark error. Investors may select reference standards that don’t accurately reflect the contents of their portfolios, and thus aren’t useful frames of reference. Benchmark error can occur in this setting because although the investor performed the math correctly and tracked performance of both the portfolio and the benchmark, it wasn’t a meaningful comparison. Essentially, the investor has compared apples and oranges.
As people make changes to a portfolio to diversify, get into new investments, or get rid of old investments, they may end up creating a benchmark error. The change in the investment mix could make an old standard a poor candidate. Investors adjusting their investment strategy should make sure their references change accordingly. Establishing a new benchmark can ensure the portfolio’s performance is accurately tracked from the start to reduce the risk of errors and create a reliable baseline.
In some cases, multiple benchmarks may be used for a portfolio. This can be advisable if there’s a broad mix of assets and no one reference provides an appropriate assessment tool. Investors using multiple references need to be especially watchful for benchmark error, because it can be easy to make mistakes in calculations, or to apply standards inappropriately on the basis of old information. They may over or underestimate the percentage of a particular kind of investment in the mix, for example, which can create a ripple effect of errors as they start to calculate performance.