When I’m driving home from work each day, I usually listen to the news on the radio. I like the routine. I don’t have a lot of time during the day to be checking the headlines, so hearing a condensed version of the news on my 15-20-minute drive home works well. I hear about the most pressing world events. I hear the forecast for the next day. I hear the latest business news. And around 5:04 p.m., I hear “stocks closed up today”, “stocks closed down today” or “stocks closed mixed today”. They’ll follow that up with “The Dow was up 32 points” or “The S&P 500 was down 10” or something like that. The radio isn’t the only source that quotes an index like the Dow or the S&P 500. Most financial websites have those indices posted right on their home pages. Local newspapers highlight the Dow. My previous employer’s building even has a sign by the street so that you can see how the Dow did while you’re listening on the radio to how it did!
All that to say, when I hear headlines of how stocks performed, I’m usually hearing about the Dow Jones Industrial Average (DJIA) or the S&P 500. The DJIA and S&P 500 indices help measure the performance of large-cap US stocks. Interestingly, the DJIA is only made up of 30 companies’ stock (compared to the tens of thousands of companies that are publicly traded worldwide), yet seems to be the most widely quoted stock index on major news outlets. The S&P 500 is made up of more companies than the Dow, but it is still focused on large-cap US stocks.
Problems With The Dow And S&P 500
So, why does this all matter? It’s not harmful, deceitful, or inaccurate to quote the DJIA or the S&P 500. The problem arises when investors don’t understand how much exposure their portfolio has to large-cap stocks. They tend to overlook the fact that if they have a well-diversified portfolio, they might also have exposure to mid-cap US stocks, small-cap US stocks, international developed stocks, emerging markets stocks, short-term bonds, inflation-protected bonds, money markets, high-yield bonds, commodities, REITSs….you get the point. I’m not saying all investors should have those specific assets in their portfolio, but if they fully subscribe to the idea of global diversification, it wouldn’t be unheard of to own those types of assets.
If an investor does own a globally diversified portfolio that consists of both stocks and bonds, how much of their portfolio really is invested in the types of companies that are in the DJIA or the S&P 500? It depends, but in some cases, it might be less than 20%. But, while maybe 20% of their portfolio is in the types of companies that are in the DJIA, 100% of the stock market news they listen to is related to those companies!
You might see the problem this creates. Often times, after hearing about how the stock market performed, investors will check their account performance. They realize their account did not perform like the DJIA…sometimes for the better, other times for the worse. Maybe it’s a LOT different than the DJIA, which can evoke a wide range of emotions. Possibly the worst result that can come from this is that an investor makes major changes to their account based on a misunderstanding of what they heard on the radio, or a misunderstanding of how their portfolio is positioned.
Appropriate Portfolio Benchmarks
We’ve established that the DJIA and the S&P 500 aren’t always appropriate benchmarks for a well-diversified portfolio. If you want an appropriate benchmark for how your account performed, a good place to start is to check out the benchmark that each mutual fund in your portfolio uses. You can get that information from the prospectus, Morningstar, or other third parties, just know that different sources might list different benchmarks for the same fund so you might need to do more investigating before identifying the most appropriate benchmark. If you own individual stocks or bonds, it gets trickier to identify an appropriate benchmark, but hopefully if you’re investing in individual stocks or bonds on your own, you have the expertise to know what benchmarks would be appropriate. Once you do identify the best benchmark, look up the performance of that benchmark, and then create a weighted average to come up with an estimate of the benchmark return for a portfolio like yours.
Focus On What You Can Control
Here’s the best advice yet – don’t focus on performance! You have little – if any – control over the performance of your portfolio. Focus on things you can control, like diversification, low cost, and how much you’re saving and/or spending. Also focus on the bigger picture, not just your investments. Spending time trying to figure out why your account returned 1.23% less than the benchmark while you ignore the fact that you’re paying too much interest on your credit cards, aren’t taking advantage of strategies to lower your taxes, or procrastinating on setting that appointment with an estate planning attorney isn’t wise.
Here’s the take-home: understand how your portfolio is positioned, understand what news you’re absorbing, and focus on what you can control. If you don’t understand how your portfolio is positioned, and you’re doing the investing yourself, perhaps it’s time to consider outsourcing the investment management to a fee-only advisor. Fee-only advisors like us at Flagstone spend a considerable amount of time educating investors to help them navigate news and avoid making mistakes based on emotions that come from reading the headlines. We’re primarily financial planners, meaning we take a look at all areas of your financial picture instead of just focusing on investments. If you want to continue managing your portfolio on your own, you need to understand the benefits of global diversification, and understand that you don’t typically hear about all types of assets on the news.