Why Investors Shouldn't Chase the S&P 500 or Any Benchmark
As the stock market continues to reach new highs amid a historic bull market run of more than nine years, investors are becoming much more attuned to their portfolio returns – some obsessively so.
Driven by fear of underperforming the market, many investors tend to focus their attention on stock market benchmarks such as the S&P 500 as a way to gauge their own investment performance. The problem is that these benchmarks have little to do with their own investment objectives, which should form the basis for their investment decisions.
The Best Benchmarks Are Not Indexes, But Your Own Goals
Benchmarking has its place for identifying potential investments, but when it is used as the primary measure of investment success, investors may be taking their eye off the real target which is their own investment goals.
Dalbar Inc., which has been conducting investor behavior studies for the last 14 years, has found that making investment decisions based on short-term fund performance and benchmark comparisons exposes your portfolio to unnecessary risks and costs that are bound to eat away at your long-term returns. Their research shows that investors who try to time the markets and select investments based on past returns rarely outperform the market. 1
Source: DALBAR, as of 12/31/2017; Past performance is not indicative of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.
The Media Noise Can Be Deafening
Investors who intently follow the financial media are more likely to react in sympathy with the herd when short-term events such as market crashes or fiscal cliffs consume the headlines. While this month’s investment returns or calamitous economic event may be consequential to our lives at the moment, their impact on the markets, and, therefore, our portfolio over a 10- or 20-year time frame is so minimal as to cause nothing more than a tiny blip on your long-term performance.2
Between the investment guru’s, TV pundits, social media and the folks around the water cooler, it has become a deafening world, and all that noise has very little to do with your specific goals and objectives. The short-term gyrations of the markets are driven as much by “herd mentality” as they are by fundamentals and the two are very rarely in sync.
While gathering information and educating yourself are essential parts of the process, it should be done in the context of your clearly-defined objectives and a well-conceived long-term investment strategy. This keeps investors from falling into typical investment traps, such as chasing performance or trying to time the markets.
Stop Checking Your Portfolio Performance
Investors who scour their account statements each day, week or month, or blink at every drop in the market are more apt to want to “tweak” their portfolios or compare their investment performance with market benchmarks. The problem is, because of its volatility, the market or any stock is just as likely to be down at the particular moment you check your account as it is to be up. When investors see negative numbers, their emotions often control their decisions.
According to a behavioral finance study,4 investors dislike losing money more than twice as much they like making money. So, investors who frequently check their portfolios tend to perceive investing to be riskier than investors who don’t. The study found that investors who check their portfolios frequently take the least risk, which leads to underperformance. Since the market or stock declines are only temporary, why put yourself in the position where you may have a destructive, emotional reaction?
Focus on What’s Important
Investors who, instead, focus on their investment performance relative to their own benchmarks established through thoughtful planning, are able to achieve more consistent and stable returns. Investor benchmarks tied to specific investment objectives are much more absolute and meaningful than a market index that has little to do with you reaching your financial goals.
For instance, if you determine that your retirement goal, set for a 20-year time horizon, requires that you earn a 7% risk-adjusted annual return on your investments, what should it matter whether the S&P 500 gains 35% one year and loses 25% the next. It’s comes down to understanding the difference between required returns – that which is needed to achieve your financial goals – and desired returns, which might equate to beating the benchmarks each year. As long as your total portfolio is on track with your required returns, as measured at regular milestones, you really don’t need to distract yourself with the daily, monthly, or even annual minutia of the markets.
You need a strategy based on your investment objectives, preferences, priorities and risk tolerance because they are the only benchmarks that matter.
Align Your Investments with Your Goals
The investment mistake many people make is to invest without a well-conceived financial plan and a sound investment strategy to achieve it. Their investment decisions tend to be market-driven or risk- driven as opposed to goals-driven, and that typically results in knee-jerk reactions and second-guessing, which is not conducive to consistent, long-term performance. Make sure to align your investments – whether capital appreciation, current income or liquidity - with your life goals, as shown in the chart below.
The Dalbar studies also clearly show that investors who adhere to a plan with clearly defined objectives and a tailored investment strategy managed with patience and discipline outperform those who don’t. A well-conceived investment strategy helps investors avoid costly behavioral mistakes.3
- Having a plan enables you to stay focused on your individual benchmarks, rather than market benchmarks or indexes, which are meaningless to your long-term strategy.
- A plan keeps you firmly grounded in risk management principles that closely track your personal risk profile while optimizing your asset allocation.
- More importantly, strict adherence to a plan shields you from the irrational behavior of the herd which is often driven by euphoria or panic.
Benchmarks don’t fund your investment goals. Only an investment strategy can do that. Without an investment strategy based in sound principles and practices, many investors succumb to the emotions of greed or fear which causes them to act in ways that are counter to their long-term objectives. It must start with clearly defined goals and targeted objectives with a specific time horizon, so you can determine how much you need to invest, the required rate of return needed to achieve your objective, and how much risk you will need to assume to achieve that rate of return.
Finally, invest for your own purposes and keep your eye on your target. That is the only benchmark that really matters.
1,2,4 Dalbar Inc. Quantitative Analysis of Investor Behavior 2018 QAIB Report. For period ending December 31, 2017.
3PsyBlog. Nobel Prize-Winning Research on Risky Decision Making. March 2007
About Signet Financial Management
Signet Financial Management is a wealth management firm that takes a personal approach in helping high-net worth families, individuals, and business owners navigate the complexities of managing money. We believe in your financial well-being, and custom tailor solutions using sophisticated investment management tools to help you keep more of what you earn and to reach your financial goals.
Unlike many firms, Signet manages portfolios using in-house research and portfolio management. Because we rarely use outside managers, we can manage your money at a lower cost to you. This can translate into higher returns over time.
Founded in 1988, we manage approximately $800 million in assets with offices in Parsippany, NJ; Reston, VA; Chapel Hill, NC; Ft. Lauderdale, FL; and Naples Fl.