Investment benchmarks are unavoidable. Pull up any financial website and the first thing you’ll likely see is how the S&P 500 or Nasdaq composite is performing. Market indices are plastered across our screens and tracked right alongside our own portfolios on financial websites and statements.
They’re there for a reason: Benchmarks are the universal language of the financial markets. They’re what we talk about when we talk about the stock market. For better or worse, they’re also the lens through which we frequently measure our own performance.
Benchmarks are the mirrors into which we ask, “Am I faring best of all?” We want to know how our portfolio returns stack up against the stock market.
What we should be asking is, “Why do I care?”
The dangers of benchmarking. A benchmark is one way of measuring your progress toward a goal, but it may be an artificial one, says Andrew Crowell, vice chairman of D.A. Davidson & Co. Wealth Management in Los Angeles.
His clients often tell him their goal is to beat the market. To which he replies: “If the market is down 30 percent but your portfolio is only down 20 percent, will you be pleased?”
No, they say; we don’t want to lose money.
So, beating the market really isn’t their objective, Crowell says. And if that’s the case, why let a market index dictate your success or failure as an investor?
Misusing benchmarks can lead to bad investment decisions and poor outcomes for investors, because benchmarks are not the impartial judges we make them out to be.
[See: 7 Investing Lessons Dad Forgot to Teach You.]
Benchmarks look backward. All a benchmark can tell you is how certain types of investments have performed in the past, says Tim Paulin, senior vice president of investment research and product management at Cincinnati-based Touchstone Investments. When you’re too focused on the rearview mirror, you run the risk of steering yourself off course.
“In a rearview mirror you often make decisions that aren’t about what you want to achieve in the future, but rather what occurred in the past,” he says. The question that should concern investors is not what has done well but rather what will do well going forward. A benchmark can’t tell you that.
Benchmarks are biased. Benchmarks attempt to track segments of the market through the weighted average performance of a selection of investments. The Dow Jones industrial average, for instance, uses 30 of the largest companies in the U.S. This is all well and good for the Dow, but if you’re not a large-cap investor, why should you care what the stocks of 30 major U.S. companies are doing?
[See: 7 Overlooked Large-Cap Dividend Stocks.]
You wouldn’t want to compare a small-cap mutual fund against a large-cap index any more than you would measure a pitcher’s performance against a class of infielders, Crowell says.
When you have an index like the S&P 500 that’s not only large cap-focused but also market-weighted, so the largest of the large stocks have the greatest influence on its performance, this bias is amplified.
“The FANG stocks control a lot of the S&P 500,” Crowell says. Even a large-cap fund will deviate from the S&P’s performance if it doesn’t own the FANG names of Facebook ( FB), Apple ( AAPL), Netflix ( NFLX) and Alphabet’s Google ( GOOG, GOOGL).
Find a benchmark that reflects your portfolio. Many investors reference everything against the S&P 500 when what they should do is use what their fund is comprised of to find a more appropriate benchmark, Crowell says.
You want to make sure your investments are “delivering returns at the top of their peer group,” he says.
You can see this on U.S. News & World Report’s stock and fund profile pages. In addition to ranking investments within their peer group, such as large-cap growth or top dividend stocks, profile pages show how company fundamentals and mutual fund or ETF returns compare to their category average.
Create custom benchmarks for better comparisons. Our portfolios are as unique as our investment goals and life situations; “why would we use the same benchmark?” Crowell says.
Once you’ve identified your goals, time horizon and risk tolerance, “it’d be appropriate to create a custom index that represents how you’re planning to allocate your portfolio,” he says. He doesn’t know of any free services to do this, but “certainly financial advisors have the capability.”
Don’t let benchmarking overcomplicate investing. Jason Browne, chief investment strategist at San Francisco-based FundX, warns custom benchmarking may be more trouble than it’s worth. All you’re going to see is your portfolio is up 6 percent and the benchmark is up 6 percent, he says.
If “you’re trying to use these benchmarks to give you context through which to view your performance,” you can do this more effectively with broad-based indices by comparing each of your portfolio’s components to the index’s returns, he says.
For instance, if your portfolio is up 6 percent but the S&P 500 is up 8 percent, you can drill down to see which of your investments is holding you back. Perhaps you find foreign stocks are lagging. Since you want international exposure for diversification, you decide it’s OK that you’re 2 percentage points behind the S&P right now.
When people try to fit a benchmark to their portfolio, “it becomes harder to hold yourself accountable for your allocation,” Browne says.
[See: 9 Strategies for Tapping the World’s Growth.]
Your goals are the best benchmark to use. You chose to allocate your portfolio differently from the S&P 500 because you thought it would better serve you in reaching your goals. Ultimately, it’s achieving those long-term goals that matters, not what the S&P 500 is doing.
Being mindful of how your investments are keeping you on track toward your goals is the best benchmark you can use, Paulin says.
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Stop Using the Wrong Benchmark for Your Investments originally appeared on usnews.com
