In the section of our website called “On Performance” we explain why the usual stock benchmarks are often not a good basis for comparison of your portfolio’s performance. This may sound surprising (and maybe self-serving) because in much of the financial world there is an obsession with beating the market. As we explain on our website, one example of why indexes aren’t great for comparison is that sometimes the whole index becomes distorted by one overpriced sector. This happened with the tech bubble in the 1990’s. In these cases under performing the index is not a bad thing, and attempting to do better than the index leads investors to take much more risk than they want or is appropriate for their circumstances. In the late 90’s investors who wanted to beat the market had to invest in highly speculative tech stocks with no earnings and sometimes even no products.
The recent reshuffling of the Dow Jones Industrial Average, the venerable index of 30 blue-chip stocks, calls attention to another distortion that makes indexes questionable benchmarks for portfolios. The owner of the index S&P Dow Jones announced last week that it would swap three of the stocks. Bank of America, Hewlett Packard and Alcoa were out, and Visa, Goldman Sachs and Nike were in. The decision led to barrage of criticism from financial commentators who pointed out that the index is increasingly outdated and irrelevant. It owns too few stocks, owns the wrong stocks and weights the stocks improperly (by share price rather than market cap) they said.
This all may be true, but the thing that particularly concerns us here is the “replacement effect” of the change. When S&P Dow Jones made the switch they reshuffled the calculation so that the value of the index did not change as a result. If an investor tried to do the same thing, owning a portfolio that exactly matched the index and selling the underperforming stocks like Alcoa and HP, he would have realized a loss and had fewer dollars left to purchase the new stocks. There would also be trading costs incurred by the buying and selling. Other broader indexes such as the S&P 500 or the Russell 3000, while perhaps more accurate than the Dow, have similar problems.
One study tracked a portfolio that matched the Dow index exactly starting November 1, 2005 and ending September 11, 2013 after the recent changes were announced. The experiment found that because of this replacement effect the index returned 45% while the actual stock portfolio returned a little less than 30%.
Now add to this the effect of management and trading fees, taxes, and the fact that most portfolios must hold onto some amount of cash. All of these things weigh on a real portfolio’s performance, but not on that of an index. As a real investor with a real portfolio, an index is an artificial and unrealistic measure of success. Beating the index is a lot harder and rarer than the financial press makes it seem.
The problem with the market-beating mentality, however, is not just the academic question of whether the index is an accurate measure of the market or an investment portfolio. The real problem is that the competitive drive to top the market can lead people to take on an inappropriate level of risk. Investment returns should always be measured in light of risk. Increased risk might produce better returns, or it might not. Good performance, however, doesn’t necessarily vindicate an investment decision. For instance if a drunk driver gets you to your destination on time that doesn’t make it okay that he was drunk. You’ve still taken an inappropriate risk. It matters how you arrived at the performance, how much risk you took, because tomorrow the risk may cut the other way.
There’s nothing wrong with keeping one eye on the index to see what’s going on in financial markets, but investors should focus more on whether they are taking an appropriate amount of risk and whether they are meeting their investment objectives rather than on beating the market. Investors should also keep in mind that some of the most important attributes of a good portfolio are things that cannot be easily quantified and don’t necessarily appear in performance numbers. These include liquidity, transparency and stewardship—knowing what you own—as well as having a good relationship with an advisor who knows your personality and your financial situation well.