Set up a custom benchmark to see if you've added value with security selection.
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By Christine Benz | 12-26-11 | 06:00 AM | Email Article

Overconfidence is the bane of successful investors. When we think we're smarter investors than we actually are, we may be inclined to take outsized risks or we may chalk up successful moves to skill even when they were just dumb luck.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

That kind of swagger may be particularly prevalent for those amassing savings in a retirement plan because your own ongoing contributions help pad your bottom line. Even in terrible market environments like that of 2008, additional investment contributions help cushion the losses, and they help give returns extra zip when market conditions get better.

So don't assume that all of your past portfolio decisions have been spot-on simply because your retirement portfolio keeps going up in value. You owe it to yourself to put your holdings' performance into context. Has your security selection really been good, or would you be better off sticking with a plain-vanilla index-fund-based portfolio?

If you've set up a portfolio on Morningstar.com's Portfolio Manager, you can use the My Performance tab to look at your results alongside several other stock and bond indexes.

But pure stock and bond indexes are pretty blunt instruments for evaluating your retirement portfolio. They're mostly going to tell you whether your stock/bond mix has helped or hindered versus a portfolio composed entirely of stocks or bonds; they're not going to tell you how good your security selection has actually been. To do that, you need to evaluate your own returns alongside those of a customized benchmark that mirrors your own portfolio's allocation among stocks (both U.S. and international), bonds, and cash.

Setting up such a benchmark is simple and can be an invaluable way to determine whether changes are in order. If it turns out that your returns have lagged your benchmark (as well as stunk in absolute terms) over an extended period of time, then and only then should you think about undertaking changes. You might decide that rather than attempting to beat your benchmark, you're better off simply constructing a portfolio composed of inexpensive index funds.

Here's how to set up your own benchmark and use it to evaluate your performance.

Step 1: Check up on where you are now.
The starting point for creating a customized benchmark portfolio is to take a look at your retirement portfolio's current positioning based on Morningstar's X-Ray tool. The beauty of X-Ray is that it drills down into mutual funds to see what they actually own--for example, if you own a stock fund that's holding cash, your asset-class distribution in X-Ray will reflect both cash and stock holdings, rather than chucking the entire fund's allocation into stocks.

If you don't already have a portfolio stored on Morningstar.com, the easiest way to X-Ray your portfolio and save your holdings for future reference is to use Morningstar's Instant X-Ray tool. Enter the tickers for each of the securities in your retirement portfolio (CASH$ if it's a certificate of deposit, money market fund, or some other cash instrument), then click Instant X-Ray. You can enter your retirement accounts separately (for example, IRAs and 401(k)s) and then use the "Combine" feature when you want to X-Ray, or enter all of your retirement holdings as a single portfolio. 

You'll see your portfolio's allocation to equities, bonds, cash, and "other" (encompassing securities such as convertibles and preferreds), as well as its sector weightings and distribution within Morningstar's stock and bond style boxes. Take note of these distributions--in particular, the allocations to U.S. and foreign stocks, bonds, and cash.

If you want to save your portfolio for future use, click Save as a Portfolio at the top of the page.

Step 2: Set up a benchmark portfolio.
To create a simple benchmark portfolio that mimics your own retirement portfolio in terms of its asset-allocation mix, calculate your exposure to each of the major asset classes--U.S. stocks, foreign stocks, bonds, and cash--in dollar terms. For example, if Instant X-Ray says that your portfolio contains 34% in bonds, 42% in U.S. stocks, 15% in foreign stocks, and 9% in cash, and your total portfolio is $1 million, your weightings would be $340,000 bond, $420,000 U.S. stock, $150,000 international stock, and $90,000 cash.

After that, click on Instant X-Ray from the Tools cover page of Morningstar.com. This time, start with a new screen for Instant X-Ray--separate from the screen where you entered your own portfolio holdings. Using index funds that correspond with each of the major asset classes, enter a new portfolio that reflects your own portfolio in terms of its asset allocation. (Enter "CASH$" for your cash holdings.)

Using the example above, the portfolio would consist of the following:

Then click Show Instant X-Ray and Save Instant X-Ray Holdings as a Portfolio. Name this one "Benchmark Portfolio." (Note: I used Vanguard funds for the benchmark portfolio because the firm's international index fund includes emerging markets, but you could easily use similar index funds or exchange-traded funds from other providers if you'd like.)

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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