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Last week we looked at creating a weighted average benchmark for your portfolio, a good option for those who want to monitor investment choices within asset classes. To see if asset allocation is working for you, you could also simply use the TSX as your benchmark. Both of these are types of relative benchmarks. Today we'll take a look at the concept of an absolute benchmark.

A relative benchmark is used to assess your performance relative to an opportunity set or a proxy for that opportunity set. For example, the TSX Composite Index is a proxy for Canadian equities, even though the index is comprised of a few hundred stocks amid a sea of thousands. But since the few hundred stocks comprising the index make up the majority of the dollars invested, it serves its purpose. The index is the proxy, but all Canadian stocks are the opportunity set (in this case).

Relative benchmarks are important for assessing various aspects of your investment decisions, to see how well you are stacking up against the average. But absolute benchmarks are more important for assessing your performance towards achieving certain goals.

For example, perhaps your financial plan indicates you need $500,000 in your RRSP by the age of 65. Given what you have now, plus ongoing further contributions, that might require an annualized rate of return of approximately 4 per cent. This is valuable information. Many people understand that risk and return are related, although personally I believe that understanding is very poor. Accommodating a lower amount of risk in a portfolio to achieve only the rate of return you need might increase the chance that your financial plan will succeed.

If your financial plan incorporates rate of return projections of 10 per cent annualized, perhaps you are now scheduled to retire at 60 instead of 65. Great. Except there is a greater likelihood that market downturns - especially at the wrong times - can dramatically alter your plan. In a worst case scenario, you might never be able to retire.

As you reduce risk or equity exposure, the variance of possible outcomes around your projections narrows. Sure market meltdowns at the wrong time will still hurt, but instead of delaying retirement by 10 years, they might delay retirement by only two years.

If you don't have a financial plan, get one. Even if you are a DIY investor. Understanding what you need to have versus what you would like to have could change your perspective on your portfolio.

There's nothing wrong with striving for higher returns but it's important to understand the risk that you are taking on. In some cases, it might work out well and you will achieve your goals ahead of schedule. It will, however, be much more painful if it works out the other way.





Preet Banerjee is a senior vice-president with Pro-Financial Asset Management. His website is wheredoesallmymoneygo.com.

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