Brice Carter, CFP®, ChFC®, CIMA®
When someone says “the stock market,” often the images that come to mind are screaming traders in blue jackets or a large mahogany desk perched atop the glass and steel of Wall Street’s skyscrapers. While everyone has a different image of the stock market, when gauging how well the market is doing, most investors think of the same two market indexes—Dow Jones and S&P 500. The Dow Jones index and the S&P 500 index are the ones constantly put in front of us via the news, radio and investment statements.
Why Dow Jones and S&P 500 Indexes Are Not Good Benchmarks
The Dow Jones and S&P 500 indexes serve as benchmarks used to grade our portfolios and our financial advisors’ performance. It is human nature for us to want to know how well we are doing in any given task, including investing. The problem with using these two popular indexes as the comparison is that investors are often much more diversified and conservative then these two classic benchmarks. Using the common two indexes as a benchmark can be problematic since each one of them has a fairly limited focus. The Dow Jones encompasses only 30 of the largest U.S. companies, and the S&P 500 contains 500 large U.S. companies.
In contrast, many investors often have other asset classes inside their portfolio such as bonds, international stocks, small stocks, and hard assets. As investors add more and more asset classes to their portfolio, they are attempting to broaden their diversification. When diversification is added correctly, investors will experience less correlation with the market and ideally less volatility. Investors should be conscious of the fact that a diversified portfolio will not mirror the market and they should not want it to either. By adding diversification, investors can often experience better long-term performance with less volatility. (For related reading, see: The Importance of Diversification.)
It is pretty clear that the Dow and S&P 500 are not good benchmarks for diversified portfolios, however, what can be lost in that logic is how using those indexes as benchmarks can negatively influence investors via basic behavioral finance tendencies. When investors eagerly watch the indexes, certain tendencies can be created, such as short-term unrealistic return expectations in up markets (2013) and increased panic during down markets (2008). The emotions caused by these unrealistic return expectations and panic from down markets can lead to poor investment decisions driven by fear or greed.
Warren Buffet was once quoted as saying, “Be fearful when others are greedy and greedy when others are fearful.” Despite Mr. Buffet’s common-sense investing tip, study after study has supported his view that retail investors make poor decisions, and as a result drastically underperform the indexes. (For related reading, see: The Financial Markets: When Fear and Greed Take Over.)
Use a Blended Benchmark From a Financial Advisor
Recently, Vanguard produced a white paper titled “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha.” In it they detailed how much value an investor can really get from using a professional financial advisor. In the study, Vanguard concluded that simple behavioral finance coaching by a financial advisor can add as much as 1.5% a year to returns vs. the average investor. Furthermore, Vanguard concluded that up to 3% a year of value could be added by employing a financial advisor.
As an alternative to watching the indexes, investors should ask their financial advisor for a blended benchmark. A blended benchmark combines multiple indexes from different asset classes and then weighs those benchmarks to match the asset allocation of your portfolio. A blended benchmark will give you a better idea of how well your portfolio is doing compared to the broad market as opposed to one asset class in one country. By watching a blended benchmark that is similar to your blended portfolio, investors should be less inclined to invest aggressively when the major indexes are out-performing or run and hide when they fall from the record highs they have been flirting with as of late.
A strategy involving diversification does not ensure a profit and does not protect against a loss in declining markets. Past performance is no guarantee of future returns. The Dow Jones Industrial Index and the Standard and Poor's 500 Index are considered to be representative of the larger U.S. stock market. It is not possible to invest directly in an index.
The commentary in this article reflects the personal opinions, viewpoints and analyses of Brice Carter, and should not be regarded as a description of advisory services provided by Financial Strategies Group, INC or performance returns of any Financial Strategies Group, INC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this article constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Financial Strategies Group, INC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.