Where Indices and Your Goals Diverge
No index can match a portfolio designed to meet very personal goals (retirement timeline, children's educational needs, etc.) or to respect personal tolerances for various risk factors. Moreover, your investment adviser has likely constructed your portfolio to minimize frictional costs (trading costs, loads, commissions, capital gains taxes, management fees, account fees, etc.) that must be paid when moving funds in and out of investments.
Indices, on the other hand, have no frictional expenses because they are an imaginary group of stocks held in a cost-free portfolio. Therefore, even if your portfolio were an exact match of an index's underlying holdings, it would be hard to outperform them.Indices are impervious to inflation and compound interest, both of which are very important concerns for the individual investor. Chasing indices (and trying to match their returns, tick for tick) is really trying to time the market, which is not a sound, long-term financial plan. The Best Benchmarks Are Your Goals Is your portfolio (holdings and allocations) designed for your goals within your time frame and risk tolerance? The answer is different for everyone. Retired investors, for instance, are usually focused on preserving principal already earned and keeping up with inflation. Younger investors may deliberately seeking volatility in search of higher returns. There's no question it takes a lot of will power to overcome emotional reactions to sudden market moves, especially downward ones, because those moves trigger numerous cognitive biases that prevent us from behaving rationally. As humans, we perceive negative news to be more important than positive news (Negativity Bias, Michel-Kerjan & Slovic, 2010) which affects our ability to properly assess risk (Probability Neglect, Sunstein, 2002) leading us to make immediate emotional decisions even if they override our long-term goals (Projection Bias, Grable, Lytton & O'Neill, 2004). Indices, What Are They Good for? This is not to say indices are inherently worthless. They can provide valuable historical overviews, among other things. However, they are just one tool to use on your way to achieving your goals, not a roadmap. This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.