By Matt McCoy
Learn more about Matt on NerdWallet’s Ask an Advisor
How often do you compare your investment portfolio performance to that of the overall domestic stock market, namely the S&P 500? If you are like most investors, you probably have fallen victim to this all too often. We have been conditioned by the financial industry to use these popular market indices as a way to directly compare our portfolio performance. And as human beings, we sure do love to compare our circumstances relative to that of others, don’t we? But is this a fair comparison for your investment portfolio?
Let’s start by taking a brief look at the mechanics of the S&P 500. The index is made up of 500 large-cap companies whose common stock trades on the New York Stock Exchange or NASDAQ exchange. Each of the holdings within the index is then weighted by their total market capitalization—the larger the company, the larger its weight in the index. The index is rebalanced on a quarterly basis.
Now take a look at your portfolio. Are you invested completely in the common stock of large-cap companies? Do you follow a strict policy of rebalancing your holdings on a quarterly basis using these same rules? In all likelihood, the answer to both of these questions is no. The chances are pretty good that you have followed the golden rule of diversifying your assets and thus hold some combination of fixed income, small-cap equities, international equities or commodities within your portfolio. And the chances are even better that you have found yourself disappointed in your portfolio’s performance relative to the market on at least one occasion.
So why are we so inclined to compare our performance this way? It’s simple: Because the information is readily available, all the time! From a convenience standpoint, financial news outlets report these numbers ad nauseam, and if we’re in a hurry then they are what we grab onto.
That’s not to say that comparing market index values has no value. Comparing the current level of the market index to past values can give you an idea regarding the current (up or down) trend in the market. It can also serve as a good acid test to indicate the general move in equity prices on a given day.
By now you are probably asking, What should I be using to measure my relative performance? The answer is different for each investor, but nonetheless simple: Use your financial goals as your benchmark for performance. So the first step is to create the benchmark by determining what return you will need in order to reach your financial goals. Oddly enough, by working through this exercise you will also determine how much risk you can bear—something the market index doesn’t know about you. When we take the time to quantify and really define our financial goals, very few of us can afford to take the amount of risk inherent in the market portfolio indefinitely. Let’s look at two examples to tie this together.
Assume you (or your financial planner) have determined that you must earn a net return of 5% per year over the next 20 years in order to reach your financial goals. Without getting into the details surrounding portfolio construction, let’s assume you have established a portfolio with an expected return of 5% that carries acceptable risk. The first year is full of positive economic surprises and the S&P 500 surges 25%. Your portfolio returns a respectable net return of 8% in that first year. How do you feel? You probably feel cheated, even though you outperformed relative to your goal of 5%.
Now let’s look at an example from a different angle. You have met with your financial planner and determined that you need to have $500,000 in five years in order to fund your retirement. You take a look at your current investment portfolio and your current balance is $750,000. Assuming you experience the same market environment from the first example, should you be disappointed? Absolutely not! Your goal in this situation would be to make sure you have what you need when you retire.
I have made some simplifying assumptions in the examples above, but the main point is still valid. You should be using your financial goals as your performance benchmark rather than using a general market index. You will most likely be setting yourself up for disappointment—and lost sleep—if you rely too heavily on the market index for performance comparison. Engage a professional, quantify your goals and your benchmark, and get some sleep!