In many spheres of life, we play the comparison game — usually to our detriment. One day we’re perfectly content driving our five-year-old Ford. The next day, when our neighbor pulls up in a brand new car with all the latest bells and whistles, suddenly our car seems like an old clunker.   

Social scientists have long noted our tendency to base our happiness on comparisons with other people or with our own circumstances in the recent past. They use the term “hedonic treadmill” to explain why a pay raise (or a new car or any other lifestyle upgrade) feels great initially, but then we get used to it and start wanting something more.

What exactly is "the market"?

When it comes to investing, having a point of comparison is not inherently unhealthy. In fact, the opposite is true if you choose the right benchmark. Unfortunately, it’s common to choose the wrong benchmarks and that can make for much unhappiness and unproductive behavior.

For many investors, the benchmark of choice is “the market” — whether that means the S&P 500, the Wilshire 5000, or the Dow Jones Industrial Average. There are three potential problems here.

First, those benchmarks are quite different from each other. The S&P 500 measures the composite performance of 500 leading large-cap companies. The Wilshire 5000 measures the composite performance of most U.S. based publicly traded companies — large, medium, and small. The Dow measures the composite performance of just 30 large U.S. companies. On any given day, the performance of each benchmark can vary quite a bit from the other two, so which one really represents “the market”?

Second, and more importantly, the benchmark may not be representative of your holdings. If your portfolio is 60% stocks and 40% bonds, is it fair to compare its performance to an all-stock benchmark?

Third, a benchmark makes no provision for contributions or withdrawals. If you are dollar-cost-averaging (investing the same dollar amount every month) into an S&P 500 index fund, as an example, your results will likely be different than the benchmark’s results. Because you weren’t fully invested for the entire period, you’ll tend to do better than the benchmark in a down year but worse in an up year.

The best benchmark for you

So which benchmark should you use? This is something of a trick question for SMI members. If you've been a member long, or have simply looked around the SMI website much, you've probably seen us compare our strategy results to the Wilshire 5000 index. That's what we use when we talk about "the market" because it's the widest and most representative index. Most investors want some sense of how they did relative to the market as a whole, and we think that's a much more accurate picture than the S&P 500, which is probably the most commonly used benchmark.

But the best answer is actually none of the above, since none of our strategies call for investing in a single index fund designed to mimic one of those benchmarks.

Instead, when it comes to evaluating the performance of your portfolio, the most relevant benchmark is the average annual return figure you used in developing your investment plan.

How do you arrive at that figure? You mix one part historical performance of the major asset classes represented in your portfolio and three parts conservatism. In my household, we use 7% as an assumed long-term average annual return. We’d far rather be surprised by a better result than the other way around.

My personal 7% benchmark has left me especially happy with the performance of SMI’s Dynamic Asset Allocation strategy, which my wife and I use to manage much of our portfolio. If the S&P 500 had been my benchmark, I might have been disappointed with DAA’s 2013 gain of 16% since the S&P 500 gained more than 30%. And I might have been tempted to alter our portfolio to take on more risk in pursuit of better performance. Instead, I was more than pleased to share in that much of an up market’s gain using such a low volatility strategy. Of course, DAA’s market-beating performance of 13% last year left me very happy as well. 

We may have little control over our tendency to play the comparison game. However, especially when it comes to our investment portfolios, we have a lot of control over our choice of benchmarks. Choosing well will make us happier, more successful investors.

What benchmark(s) do you use with your investments?