What do we lose when we use a benchmark?

Simple

Make everything as simple as possible, but not simpler.

— Albert Einstein

Everything should be made as simple as possible, but not simpler.

— Albert Einstein

Everything must be made as simple as possible. But not simpler.

— Albert Einstein

Everything should be as simple as it is, but not simpler.

— Albert Einstein

Everything should be made as simple as possible, but not one bit simpler.

— Albert Einstein

Too simple

Benchmarks enable simple analyses.  Simple is good.  If you don’t know that I’m a big fan of simplicity, then you don’t know me.

But benchmarks are too simple.

A key problem with Value at Risk is that it reduces risk to a single number.  Risk is more than one-dimensional.  Returns have more than one dimension as well.

In the days when 60 million shares was a heavy day of trading on the New York Stock Exchange, the news reported not only the level of the Dow, but the advance/decline line — how many stocks rose and how many fell.  That was — in some ways — a fuller picture than we typically get now.

Figure 1: Self-portrait a la benchmark.

Whenever a benchmark is used, the proper response is (almost surely): “But it is more complicated — and more interesting — than that.”

Alternatives

When portfolio constraints are in play, then random portfolios are a likely replacement.  In other cases some thought may need to be put into it.  Thinking is sometimes a good thing.

Any good alternative will certainly involve graphics.  Our drive to get a single number is because numbers are hard for us.  However graphics — good graphics, that is — are easy for us.  (The reason for this is explained in Brain Rules.)

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