Benchmarks and Investor Psychology

There are millions of intelligent people in this country (don’t laugh- seriously!), many of whom invest their money in the securi­ties markets. Why, then, are there so few genuinely successful investors? In my opin­ion, the answer is simple – they do not pos­sess the psychology that is necessary for long-term investment success.

Investor Psychology, studied extensively in the field of behavioral finance, is the pow­erful driving force behind investment deci­sions. Seemingly intelligent, rational people make very irrational and potentially harm­ful decisions when it comes to their invest­ments. This leads me to our topic – to ex­plore the relationship between benchmarks and investor psychology.

When I say benchmarks, I’m simply refer­ring to market indexes such as the Dow Jones Industrial Average or the S&P 500, which are some of the more commonly used benchmarks by investors. Here at Fi­nancial Synergies, we use active fund managers to represent our asset classes, and we do analyze them against an appropri­ate index. But our focus, at the portfolio level, is never on a comparison to a stock -only index, like the S&P 500. One of the single biggest mistakes that investors make is chasing an arbitrary index thinking that they have to beat it.

This desire to compare can be a constant source of frustration and can cause inves­tors to continually do the exact opposite of what they should be doing. Comparing an individual’s diversified investment port­folio performance to a market index takes the focus off of long-term goals and can cause investors to buy and sell at the wrong times, for the wrong reasons.

If constructed properly, an investor’s port­folio is a customized allocation across many different asset classes, not just individual stocks. It is tailored to their age, lifestyle, goals, and risk tolerance. For example, a client who is now in retirement may have more than half of his portfolio allocated to bonds, whereas the S&P 500 (the “mar­ket”) consists of 500 mega-cap stocks. If we told him his portfolio return for the year was 8%, he would probably be pleased. If we subsequently told him that the “mar­ket” returned 12% for the year, he might not be as pleased with the results. If the desire to beat the market is strong enough, he may make the mistake of throwing his well-crafted investment plan out the win­dow for something more aggressive. This would be a mistake.

Is it any surprise that investors feel the need to compare their portfolios to the Dow Jones or S&P 500 indexes? I mean, in this hyper-information digital age we are constantly bombarded with irrelevant data in the media and told that it is relevant. You can hardly turn on the television or browse a website without seeing a stock ticker parade across the bottom of the screen. If you follow Jim Cramer (CNBC’s Mad Money), you might make 1,000 trades in a year! Make no mistake; this is for the benefit of the media and Wall Street. They want investors to obsess and chase after the benchmark indexes because it creates money movement in the market.

What we must understand is that Wall Street doesn’t want us to be disciplined and adhere to a long-term investment strategy. Wall Street gets paid when money is in motion (buying/selling = fees/commissions). There is a time to trade, but it shouldn’t be in reac­tion to a benchmark index. Trading or rebal­ancing within an investor’s portfolio should be driven by long-term strategic allocations, lifestyle needs, or shifts within various asset classes, but nothing more.

The truth is, most successful investment strategies are boring. They are not fast-paced nor particularly sexy. They require patiently sitting on your hands while everyone else is urging you to DO SOMETHING.

With the stock market approaching a five-year bull run, the desire to compare is be­coming stronger by the day. It wasn’t so long ago that investors wanted nothing to do with stocks.

Anyone remember the first decade of the 2000s? Over that stretch the S&P 500 pro­duced a pitiful annualized loss of -0.95%. Over the same 10 year period, Barclays Capi­tal U.S. Aggregate (US Bond index) produced an annualized gain of +6.33%. Who saw that coming? There might be long periods where an individual investor outperforms or under­performs a benchmark, and it truly doesn’t matter. What matters is having a game plan to achieve your individual goals and sticking to it.

Human nature is such that we all sometimes feel the need to compare ourselves and our lives to a benchmark. That benchmark might be your next door neighbor with the bigger house – “keeping up with the Jonses” as the saying goes. In your financial life, it may be an index you’re comparing yourself to.

Tune out Wall Street and the media’s obses­sion with benchmark indexes. If you can re­sist the temptation to compare, you will be happier in the short-term and wealthier in the long-term.

-Mike Minter, CFP^®, CFS^®