The stock market is not YOUR benchmark
The stock market is not YOUR benchmark
There are several problems with using a stock market index as a benchmark for your portfolio’s performance. For starters, there are many stock market indexes to choose from. The Dow Jones Industrial Average (DJIA) is comprised of only 30 companies, which fails to adequately represent the nearly 3,000 companies that trade on public exchanges in the United States. The Standard and Poor’s 500 Index (S&P 500) is more diversified, consisting of 500 companies but does not include mid or small capitalization companies. The Dow Jones Total Stock Market Index represents most of the publicly traded companies in the U.S. (all of those with readily available prices), but does not include any foreign securities. Many, if not most investors hold foreign securities in their portfolios. The Dow Jones Global Total Stock Market Index would be the most diversified benchmarking resource available and represents more than 12,000 securities from 77 countries and covers more than 98% of the world’s market capitalization.
This index is considered a comprehensive representation of the global stock market.
Now that we understand the components of various indexes, we can begin to compare these with your investment portfolio. If you are like many investors, you are broadly diversified across equity sectors, market capitalizations and your investments include foreign securities. If your portfolio is balanced, it is not invested entirely in stocks but also includes fixed income securities (commonly bonds) and cash or cash equivalents. A balanced portfolio is designed to reduce volatility by holding securities that “balance” each other. Historically, stock and bond prices have shown a tendency to move independently of each other. This doesn’t mean they always move in the opposite direction, it simply means that they are impacted by different factors and financial events.
Let’s assume you are a 60-year-old investor with significant investment experience, you have a moderate risk tolerance and you have at least five years before you plan to take any distributions. Based on your objectives and your financial advisor’s guidance, you have a portfolio that consists of 60% equities (stocks) and 40% fixed income securities (bonds) and cash. The stock portion of your portfolio is globally diversified, representing nearly 12,000 companies worldwide with a comprehensive equity representation. The bonds in your portfolio are intermediate term and high quality. There is enough cash to cover short term needs.
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Clearly, none of the aforementioned stock market indexes is YOUR benchmark. Stock market indexes only include stocks and are generic. Your portfolio is individualized and designed around your personal goals and objectives. The question now becomes, well if I shouldn’t use stock market indexes as a benchmark for my portfolio’s performance, what should I use? My response, the most important benchmark of all, your financial goals! If your investment portfolio is on track to meet your individual financial goals (which simultaneously means you are achieving the target rate of return), everything is working as planned.
The importance of the message here cannot be understated. Believe it or not, it is common for investors who are meeting their documented financial goals to be disappointed in their portfolio’s performance. An investor in a balanced portfolio may have a target rate of return of 6 – 7 % annualized over a ten-year time horizon but when they see the Dow Jones performing better, they may become disenchanted with their investments, their advisor, or both. As a seasoned investment professional, I can attest that I have yet to have anyone tell me their goal is to invest in the Dow Jones. Yet, several times throughout my career I’ve had investors compare their portfolio’s return to the Dow Jones Index. Goals are need and want driven, not index driven.
I don’t believe much value is gained from following stock market indexes. Investors may, however, learn a great deal from the history of the capital markets. Stay focused on your goals, monitor and adjust when necessary, re-balance to the target allocation periodically and dedicate adequate time in understanding your personal investment strategy. Leave the index following to those with less important things to do.
-Rick O’Dell
