The Optimal Choice of a Benchmark Portfolio

Abstract

The choice of a benchmark portfolio is a particularly important issue for individual investors who must worry about taxes. The traditional assumption that an investor can move to the benchmark portfolio in a cost-free fashion disappears and gives rise to additional issues. The author argues that the portfolio in place at the beginning of the investment period may well be the most suitable benchmark portfolio. Choosing the ex ante portfolio as the benchmark, the investor will find that this benchmark is simple and easy to understand and that it cannot be manipulated by the portfolio manager. Furthermore, it should be consistent with his or her investment strategy and risk aversion, provided the current portfolio represents an acceptable trade-off point between risk and return.