Stop Watching Stock Indices or You Could Destroy Your Portfolio

NEW YORK (TheStreet) -- As investment advisers, one of our biggest challenges is getting clients to focus on the big picture. In particular, many investors find it hard to break the habit of comparing the performance of various well-known stock indices to that of their own portfolios.

My message to many clients is this: Take your focus off indices and put it on your goals. Why? Because obsessing about index returns (and perceived discrepancies compared to your own investments) can cause you to abandon rationally made asset allocation choices, increasing risk and leading to costly panic buying and selling that can decimate the value of a portfolio.

Consider this: An investor who panicked in March 2009, sold $100 worth of stock and placed that $100 in a money market fund would have earned $1 more by the summer of 2013. Investors who stayed in the market over the same period saw their investments climb by approximately $44. [Source: Michael Finke, professor and coordinator, doctoral program in personal financial planning, Texas Tech University, in his 2013 article "Why Stock Investors Freak Out" in Research Magazine.]

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Understanding What an Index Is and What It Isn't

A market index is a preselected group of securities. Although indices are often referred to by the financial press as proxies for the health of the "general market," there is, in fact, no all-encompassing market index. All indices are constructed, calibrated, weighted and rebalanced differently.

  • The Dow Jones Industrial Average includes only 30 large company stocks and represents about one-quarter of the value of the entire U.S. stock market. Furthermore, the DJIA is price-weighted. This means a $1 change in the price of a $188 stock in the index will have the same effect as a $1 change in a $20 stock, even though one may have actually changed 0.2% and the other by 5%.

  • The S&P 500 , of course, tracks 500 major U.S. companies. These have been chosen to include a range of industry sectors and represents about 70% of the total value of the U.S. stock market. Yet its focus on large companies means it's not representative of the entire market, smaller stocks in particular. Furthermore, the S&P is market-weighted. If the total market value of all 500 companies falls 10%, the value of the index falls 10%. A 10% movement in all 30 stocks of the DJIA would not cause a 10% change in that index.

  • The Russell 2000 (IWM) tracks smaller U.S. companies. Note that it's market value-weighted (on market cap) of 2,000 of the smallest stocks. In other words, it tracks the largest of the small.

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.

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