Whiteboard Series: Episode 11 – Investment Indices

The start of a New Year always leads to discussion around various investment indices.  How did the stock market do last year?  What are the predictions for this year?  Investment indices are always interesting, but they are often misunderstood by investors and rarely are a good benchmark for evaluating the performance of their own investment portfolio.  Investors need to understand their own underlying investment allocation before comparing their performance to some of these broader measures.  At the end of the day, the only benchmark that should matter for investors is whether they are on track to meet their own investing goals and objectives. 


The Whiteboard Series is a continuous exploration and discussion across a wide range of personal finance topics. Through a series of drawings, interviews and explanations, we hope to educate and simplify important financial planning principles. 

Video Transcript

On today’s Whiteboard Series I want to talk about Investment Indices, and how they should be viewed in the context of your own investment strategy.  The topic of benchmarks and indices come up a lot this time of year.  We look back at the market’s performance in the prior year and start predicting what we think it’s going to do in the coming year.  Plus, with all the market volatility the past few months, every night on the news it’s “the Dow did this,” “the S&P did that.”  Indices are always interesting and CAN be helpful, but they’re often misunderstood by most investors and are rarely a good benchmark for tracking your own portfolio’s investment performance.  


A market index tracks the performance of a specific "basket" of stocks considered to represent a particular market or sector of the U.S. stock market or the economy. The most popular indices we see are the S&P 500, the Dow and the NASDAQ.  The S&P 500 is essentially 500 of the largest US companies on the market, the Dow tracks just 30 large US companies and the NASDAQ focuses more on technology and IT companies.  Some other indices include the Russell 2000 – which tracks the small cap companies in the United States – or the MSCI EAFE – which tracks some international stocks.  Bottom line, there are thousands of stock indices around today and they track every conceivable slice of the stock market.  


The problem with indices for most investors is that there’s rarely an index available that’s a good benchmark for YOUR investment portfolio.  Unless your entire portfolio is an S&P 500 index fund, the S&P 500 shouldn’t be the benchmark that you’re comparing your portfolio to.  Most investors hold diversified portfolios, that contain both stocks and bonds.  So, for example, if you own 80 percent stocks and 20 percent bonds, it’s going to be tough to keep up with a stock index because 20% of your portfolio is in some type of lower growth asset.  Furthermore, within your equity portion, there is likely large companies, mid-cap companies, small companies, and probably some international companies as well.  Taking this basket of investments and comparing it to one of these indices is futile.  You’re comparing apples to oranges.   


None of this is to say that indices are irrelevant.  Collectively, they do represent the broader performance of the stock market.  But you need to understand your total portfolio, and how to apply the indices to it.  So, let’s say the S&P 500 did 11% in a given year and my portfolio did 8%.  Well I’m okay with that because I have some fixed income in my portfolio and also own some international stocks, which didn’t perform as strong that year.  


At the end of the day, the only benchmark that really matters is whether you are on track to meet your investing goals.  Everyone has unique investing goals, a unique balance sheet and a unique savings ability.  As such, they should have different investing strategies.  If Person A did 8% on their investments and Person B did 5%, it doesn’t necessarily mean that Person A is a better investor.  Perhaps Person B is on track for their goals and doesn’t need as much return, so it’s not worth taking the additional risk.   


So again, I’m not suggesting you ignore some of the popular indices or that they are completely irrelevant. It’s just that you need to understand the construction of your own portfolio, before starting to make comparisons on a performance basis.