Investors today are inundated with information about the performance of market indexes. If you picked up a newspaper during the first three months of 2017, there’s a good chance you saw a headline about the Dow Jones Industrial Average (DJIA or “the Dow”) reaching a record high. If you turn on CNBC, the real-time performance of the Dow, S&P 500, Nasdaq, and other high-profile indexes are constantly shown on the screen.
So it’s not surprising that investors, when assessing the performance of their personal investments, tend to compare their portfolio’s performance to the performance of an index. While these benchmarks provide useful information about how the broader market is performing, the indexes are much less useful for understanding how your personal portfolio is performing.
There are several reasons why an investor’s returns can vary significantly from the returns of market indexes. Understanding these differences can help you assess the performance of your portfolio.
Portfolios and indexes have different holdings.
Quite simply, your investment portfolio’s performance won’t match that of an index because the holdings in your portfolio are not identical to the securities that make up the index. For instance, if your portfolio consists of 75% stocks and 25% bonds, you couldn’t make an “apples-to-apples” comparison with either the Dow Jones Industrial Average or the S&P 500, both of which consist entirely of stocks. Even if you had an all-stock portfolio, you likely would own some small-company stocks, which would not be represented in the Dow, which contains just 30 large-company stocks. And if you owned stocks of non-U.S. companies, these would not be included in the S&P 500, which is made up of 500 large U.S. companies.
Although the Dow is widely cited in the media as proxy for the performance of the broader stock market, the Dow is very narrow, comprising only 30 “blue chip” companies. As a result, the Dow’s performance can be significantly impacted by the performance of just a few companies. For example, in the weeks following the election of Donald Trump as president, the Dow gained more than 1,000 points – the second fastest 1,000-point gain in its history.1 Yet, just three companies – Caterpillar, UnitedHealth Group and Goldman Sachs – were responsible for about 50% of the Dow’s gains during this period.2 If your portfolio did not include any of these three companies, you might have seen far more modest gains than those attained by the Dow.
Systematic investing prevents accurate comparisons.
If you’re like most investors, you probably don’t make 100% of your year’s investments on January 1 and then sit back and do nothing for the rest of the year. You probably are investing new funds in your portfolio and/or taking money out throughout the year. If you follow a “systematic investing” approach, you put the same amount of money into the same investments at regular intervals, such as once a month, throughout the year.
Regardless of whether you invest systematically or make investments more opportunistically or irregularly throughout the year, the timing of your investments means that your portfolio’s performance won’t match a market index. An index’s performance is stated in annual returns, which means that the numbers assume a one-time lump sum investment at the beginning of the year. At the end of the year, your portfolio’s performance will reflect the fact that your funds entered (or exited) the market at various points throughout the year and that the price of the securities you purchased (or sold) are constantly changing throughout the year.
Volatility distorts returns.
Part of the difference between the performance of market indexes and that of individual investors’ portfolios can be explained by volatility – that is, the normal ups and downs of the financial markets. To illustrate: The average annual return of the S&P 500 (including dividends) was about 9.6% from 1992 – 2011, but during this time period, the yearly returns ranged from a high of +37.58% in 1995 to low of –37.00% in 2008. As a result of these disparities, the compounded annualized return – what an investor actually earned once the market volatility was factored in – was about 7.8%, nearly two percentage points lower than the index’s “average” return.3
To see a very simplified example of how compounding causes a portfolio’s return to deviate from the “average” return, consider the following: If you started with $100 and lost 10% in Year 1, you’d have $90 at the end of Year 1. But if you gained 10% in Year 2, you wouldn’t end up with your original $100 at the end of Year 2 – you’d only have $99. So while your “average” annual return would be 0% (-10% in Year 1 and +10% in Year 2), your compound annualized return would be -0.5%. Over time, the effects of market volatility would multiply, resulting in even bigger gaps between your compounded annualized return and any index’s average annual return.
Trades and expenses affect results.
A market index, such as the S&P 500, just shows the returns a lump-sum investment would earn if it were invested directly into the index (which is not possible, as an index is a group of unmanaged securities and is not available for direct investment). Consequently, an index’s returns don’t reflect any activity on the part of an investor. But your portfolio’s true performance will be greatly affected by your buying and selling. And investing involves expenses and fees, which can also influence your overall returns. So, even if your portfolio closely matched the composition of a market index, your investment activities would likely draw your performance away from that of the index.
Set your own benchmarks.
As you can see, several factors are responsible for whatever difference exists between your returns and those of a market index. But perhaps your question shouldn’t be “Why aren’t my returns equaling those of the Dow or S&P 500?” Instead, you might want to ask yourself: “Should I even want my returns to match those of a market index?”
Keep in mind that the purpose of building a portfolio isn’t to beat, or even match, the market. Rather, the objective is a build a portfolio that allows you to achieve your goals for retirement and other financial goals — while taking into account your risk tolerance and time horizon. At Leelyn Smith, we work closely with our clients to build portfolios designed to achieve these goals while minimizing risk.
That’s not to say you should ignore all methods of comparison when evaluating your portfolio. After all, it is helpful to be aware of how the equity and bond markets are performing. But given the limitations we’ve discussed regarding market indexes, you should consider using your own benchmarks to determine how well you are being served by your investments. We work with our clients to determine the rate of return needed to achieve their goals, and continually assess whether the portfolio is delivering that return.
Beyond the headlines.
Whenever the Dow or the S&P 500 reaches another milestone, it is going to generate headlines. But when evaluating your own investment portfolio and the progress you’re making toward your goals, you need to look beyond the headlines and pay attention to the bigger story. At Leelyn Smith, we’re dedicated to helping you write that story.
An index of indexes.
Investment professionals use dozens of indexes to measure various asset classes – such as stocks, bonds and commodities – and different aspects of the financial markets. Here is a quick rundown of some of the most widely followed indexes:
Dow Jones Industrial Average – The “Dow,” which is probably the most widely quoted measure of stock market performance, consists of 30 large “blue chip” companies representing a variety of industries. However, given its limited number of stocks, the Dow is sometimes criticized for not being truly representative of the overall market.
Standard & Poor’s 500 – The S&P 500 is a composite of 500 large U.S. companies. The S&P 500 is intended to be representative of leading companies in leading industries in the U.S. economy.
Nasdaq Stock Market Composite – The NASDAQ composite index covers approximately 4,500 over-the-counter stocks (stocks not listed on an exchange). This index represents many small-company stocks, but its performance is strongly influenced by about 100 of its largest stocks, many of which are in the technology sector.
Wilshire 5000 Total Market Index – The Wilshire 5000 essentially covers all publicly traded companies in the United States, and, as such, is generally considered to be the broadest stock market index. The Wilshire 5000, like the S&P 500 and the NASDAQ, is a capitalization-weighted index, in which the bigger companies have higher percentage weightings, while the smaller companies have lower weights.
Russell 2000 – The Russell 2000 covers approximately 2000 of the smallest U.S. companies, based on market capitalization. Thus, the Russell 2000 is often used to benchmark the performance of small-cap stocks.
MSCI All Country World Index – This index contains stocks from 46 countries, half of which are classified as “developed” markets and half as “emerging” markets. The MSCI ACWI contains several sub-indexes that track companies in specific regions.
Bloomberg Barclays U.S. Aggregate Bond Index – This capitalization-weighted index is the most widely quoted bond index in the world, covering most U.S. traded bonds and some foreign bonds traded in the United States.
Source: Securities Exchange Commission (https://www.sec.gov).
Indices are unmanaged measures of market conditions. It is not possible to invest directly into an index. Past performance is not a guarantee of future results.
The opinions voiced are for general information only. They are not intended to provide specific advice or recommendations for any individual and do not constitute an endorsement by LPL. To determine which investments may be appropriate for you, consult with your financial professional. Please remember that investment decisions should be based on an individual’s goals, time horizon, and tolerance for risk. LPL does not provide tax or legal advice.
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Footnotes:
1 Market Watch: “Dow Clambers Above 20,000 – Marks 2nd-fastest Run to a Milestone in History” http://www.marketwatch.com/story/dow-cracks-20000-milestone-intraday-for-the-first-time-2017-01-25
2 247wallst.com “Half of the Dow Jones Rally Just 3 Stocks: These 4 Blue Chips Better Buys Now” http://247wallst.com/investing/2016/12/06/half-of-the-dow-jones-rally-just-3-stocks-these-4-blue-chips-better-buys-now/
3 Morningstar and Crestmont Research