Investors often compare their portfolios to market indices as a means of measuring performance. However, this may not be a good idea.​

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Market indices are not quite as diversified as you might think.

Investors comparing their portfolios with returns of indices is very common in our industry. Of these indices, the two most common people compare returns to are the S&P 500 or the Dow Jones Industrial Average.

These comparisons are made so investors can find a benchmark on how well their portfolio is doing and how well it should be.

While this is a reasonable use of indices, investors can often take it too far. Sometimes it can lead to discouragement and investors abandoning portfolio strategies that appear not to be measuring up.

The Dow, for example, is one index I can’t understand why investors are still using today. This may have been appropriate decades ago but not now since the implementation of all of our modern technology.

Additionally, the Dow isn’t well diversified, having only 30 stocks, and is also a price-weighted index—meaning stocks with a higher price have more of an impact on the index.

 

 

To give an example of this, imagine if IBM were to split today. If this happened, their influence in the Dow would literally be cut in half. Looking at this example, it’s clear that the Dow is most likely not worthy of a serious comparison against a personal diversified portfolio.

Next is the S&P 500. It, too, is an imperfect proxy for portfolio performance. Many investors are misguided in believing that because it has 500 stocks, it must be really diversified. However, this isn’t the case.

Those stocks are comprised of large US companies and the S&P 500 is a capitalization-weighted index. What this means is that the larger companies carry more weight.

So while this isn’t as bad as a price-weighted index, it still causes problems. For instance: Microsoft, Apple, and Google have more power in the index than the entire sectors of utilities, telecom, and materials. Therefore, despite the high number of stocks the S&P 500 is not as diversified as one may initially think.

If you choose to compare your portfolio to a market index, keep in mind these indices simply don’t deal with some of the things an investor’s portfolio does, like risk and time horizon.

So if you have any other questions or would like more information, feel free to contact me by giving me a call or sending an email. I look forward to hearing from you.

 

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Inclusion of these indexes is for illustrative purposed only.  Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance.  Individual investor’s results will vary.  Past performance does not guarantee future results. Raymond James Financial Services and its employees may own options, rights or warrants to purchase securities mentioned.  The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material.  It has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or compelte.  This information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Jeff Green and not necessarily those of Raymond James.  This information was obtained from the Emotional Investor and used with permission.
 
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