You are not supposed to beat the index, so stop thinking that you are

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by Jerry Lynch, CFP, JFL Total Wealth Management

I read a lot of articles on investments, returns and how most people do not beat the index in their portfolio. Let me set the record straight. The question “Did your portfolio beat the index last year?” is a trick question. An index is not a portfolio and if you are beating the index (let’s say the NASDAQ or S&P) then you are probably doing something very wrong! Let me explain.

There are three major indexes that we generally compare portfolios to:
• S&P 500: This is the top 500 companies in the U.S. based upon specific criteria, not just market cap.
• Nasdaq: This was the first electronic trading market. This index has companies based in the U.S. and overseas and generally is in technology and growth companies.
• Dow Jones Industrial Average: This was first an industrial index, but now it focuses on 30 larger U.S. companies.

These track only part of the investment options that are available to you and they mainly focus on larger companies. Also, these specific indexes do not track emerging markets, international, smaller companies or any fixed income investments, so they are a very small subset of the index universe. There are hundreds of indexes out there and only using only three to evaluate performance is not a fair comparison.

A portfolio is designed around several different sets of criteria that are generally based upon the investor. These would include risk tolerance (how much are you willing to lose), tax sensitivity, income requirements, and when you need the money back, just to name a few. Let’s discuss that a little.

• Risk Tolerance: In 2008, the Dow, S&P and NASDAQ were down 33.8 percent, 38.5 percent and 40.5 percent respectively. If you do not want to lose that much money, you should not be invested 100 percent in those indexes. If your “pain” threshold was, let’s say, a 20 percent loss, the most I would have you in is 50 percent stock. If you were invested in 50 percent stock, then a good return for this portfolio would underperform the index by 50 percent.
• Tax sensitive: If you are in a 10 or 15 percent tax bracket, you qualify for tax-free qualified dividend (stock) income and tax-free capital gains. If you are in the top tax brackets (over 50 percent in some states), part of the focus has to be tax-sensitive investing. Comparisons with indexes will not take into consideration the differences on an after-tax basis.
• Income Requirements: If someone is looking to live off this income, the 2 percent dividend rate from the S&P 500 is not going to cut it. This leads to investments in things that generate income such as dividend stocks, REITs, Master Limited Partnerships (MLPs), and fixed income investments. These returns are not linked to the major indexes, so of course, they will perform differently versus these indexes.
• Diversification: If you look at the performance of the market by sector, even sectors such as cash have led in performance at certain times (i.e. 2008). A diverse portfolio gives you options and allows you to select what works best to sell at that moment in time. So using 2008 for an example, having all your money in the three major indexes would have meant that you couldn’t or shouldn’t sell. Having money in cash meant that you did not have to sell at a loss and you could allow your money to recover.

I am not an index investing hater and I support both passive and active management styles in the portfolios that we manage. In large U.S. companies, I think that an S&P 500 index fund should be a core holding of any good portfolio, however, I do feel it is very difficult to index alone, especially in areas such as smaller companies and international investing. So I feel a combination of the two strategies is a great way to develop a portfolio.

So if comparing an index to a portfolio is really not a fair analysis, how can you see if your performance is good or bad? Well, it is not easy, but you would need to evaluate every index in each area that you are invested. Even then, you may have to modify them based upon what you are investing in. For example, if you are investing in shorter duration bonds, the Morningstar Intermediate bond index has a longer duration, and you would then need to discount that.

So I think that it is always good to have a conversation on the performance of the portfolio so you can understand where and how you are making or losing money, and if changes need to be made. It is even more important that the portfolio is designed around you and helping you hit your goals and objectives, especially if you are retired.

The purpose of financial planning is not getting the highest rates of return, but rather making all your financial dreams come true with the minimal amount of risk. If you can make that happen, do not worry about what the indexes are doing!

Jerry Lynch is a certified financial planner with JFL Total Wealth Management. He may be reached at or (973) 439-1190.

This story was first posted in December 2014.

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