Popular stock indexes like the Dow Jones Industrial Average and S&P 500 are near record highs, causing many investors to take a critical look at their portfolios and find them lacking in comparison. What they often forget to do is ask themselves why their portfolios are not in sync with those indexes.
For the most part, portfolios that seem like laggards to date may contain some mixture of bonds and international equities which have not performed as well as the U.S. equities indexes so often touted by the financial media.
Ironically, those same investors probably didn’t question the inclusion of bonds in their portfolios when the S&P fell 50% as it did between August 2008 and March 2009.
Similarly, at different points the developed international markets (MSCI EAFE Index in January 2013) and the emerging markets (MSCI Emerging Markets Index in the first few months of 2013) have beaten the S&P 500 Index.
As late as December 2012 experts were touting this trend and advising further investment into emerging markets. Unfortunately, as a whole the emerging market sector this year has not beat the index, although it may be possible to find certain niche markets which did.
In fact, chasing indexes is really trying to time the markets and that, in turn, is simply relying on luck, which is not a sound financial plan. Why is benchmarking your personal portfolio’s success with an outside index not a good idea? First let’s take a step back and look at what an index is.
A market index is a preselected group of securities. Often these are cited by the financial press, TV commentators and well-spoken financial experts as proxies for the health of the market at large. You read and hear about them all day, which explains one reason they are so top of mind for many investors.
Second, no single index is truly indicative of the health of the overall stock market.
The Dow Jones Industrial Average includes just 30 large company stocks and represents about a quarter of the value of the entire US stock market. However, note that the DJIA is price-weighted. This means a $1 change in the price of a $188 stock in the index will have the same effect as a $1 change in a $20 stock, even though one may have actually changed 0.2% and the other by 5%.
The S&P 500 are 500 major U.S. companies chosen to represent a range of industry sectors and represent about 70% of the total value of the US stock market. Yet, its focus on large companies means it’s not representative of the entire market, smaller stocks in particular. Also note that the S&P is market-weighted. If the total market value of all 500 companies falls 10%, the value of the index falls 10%. By comparison, a 10% movement in all 30 stocks of the DJIA would not cause a 10% change in the S&P 500.
Do either of these match exactly your investment portfolio? It’s not very likely because most people construct their portfolios to meet very personal goals and manage personal tolerances for various risk factors.
Think of an investor setting up a portfolio. Doesn’t it go something like this? “I will retire starting in the year 2033 and will require $35,000 in quarterly cash flow from that date forward. I will allot 70% of my portfolio to this goal as long as the resulting investments meet my tolerance for loss of principal. Of the remaining 30% of my portfolio I will apply 20% towards investments which meet possible needs for liquidity. The remaining 10% of my portfolio I will keep in instruments coordinated to mature with planned withdrawals such as my daughter’s wedding and the purchase of a second home before I retire.
That doesn’t sound like any index that exists.
Further, your investment advisor has likely constructed your portfolio to minimize frictional expenses (trading costs, loads, commissions, capital gains taxes, management fees, account fees, etc.) that must be paid when moving funds in and out of investments.
Indexes have no frictional costs. They are an imaginary group of stocks held in a free portfolio with no trading costs or any other restraint like risk and volatility tolerance.
Furthermore, indexes don’t concern themselves with little things like inflation or compound interest – what Albert Einstein called the most powerful force in the universe – they just meet certain weight and percentage requirements. Yet inflation and compound have a massive impact on individual investors.
There are numerous other problems with indexes including calculation bias (meaning if the biggest player stumbles it brings the whole market down) and representative bias, which takes into account what the index does not measure.
Simply put: We all like to make money, but more importantly we like to hit our financial goals. So take your eye off the indexes and place it on what you want from your savings. The best benchmarks are not indexes but your own goals.
Are your actual holdings meeting your goals given your investment style, risk profile and cost restraints? That’s the real benchmark.
Past performance is no guarantee of future return. Indexes are unmanaged and cannot be invested into directly. International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
Jim Cahn is Chief Investment Officer of Wealth Enhancement Advisory Services, the RIA arm of Wealth Enhancement Group. Contact him at firstname.lastname@example.org.
Originally published on forbes.com