Comparing Badly

Investors desperately need points of reference or benchmarks to which we can compare the performance of our investments. That’s why we are constantly asking, “How did the market do today?” It’s tough to properly determine the relative performance of our investments when we compare them to the wrong benchmark. The most popular yardsticks by which investment portfolios are measured are the ever popular (and badly flawed) Dow Jones Industrials Average (the Dow) and the blue-chip stock index, Standard & Poor’s 500 (S&P 500). For far too long the Dow has been the go-to index when the media mentions stock market performance. When you hear an announcer saying that the “market” was up or down a certain amount, odds are they are referring to this archaic conglomeration of 30 almost arbitrarily selected large US companies. The only way this would be a reasonable benchmark against which to compare your portfolio would be if you owned a relatively small portfolio of blue-chip stocks in United States companies and none of them were in the transportation or utility business (those industries have their own tiny Dow indexes).

There has been a bit of improvement as some have started to compare portfolios to the S&P 500. Even we have been guilty of that, as so many investment studies use the S&P 500 for comparison. We hate doing it, but compared to the Dow Jones 30 Industrials, the S&P 500 is a far better index against which to measure your portfolio’s performance. For those with globally diversified portfolios, the S&P 500 is sorely lacking. It only tracks the 500 largest companies in the United States. It ignores the performance of many thousands of companies, both in the US and abroad.

Trying to match your portfolio against the wrong benchmark can cause emotional turmoil that often leads to bad decisions, particularly when the comparison is made over a short period of time. Let’s take a look back at 2011, for example. For the year, the Dow Jones 30 Industrials gained almost 5%. The Standard & Poor’s 500 index posted a tiny loss. Some might infer from those figures that a more focused investment, in a few blue-chip stocks, has the potential for greater returns. To a point, they would be right. Yet, those potential returns are offset by potentially greater losses.

Concluding that owning fewer stocks in a portfolio is better would be dramatically reinforced by the one-year performance of the Dow Jones Global Total Stock Market Index (DWG). This index, which includes more than 12,000 stocks from 64 different countries, lost almost 11% of its value during 2011. Had you purchased the Dow 30, at the beginning of 2011, you would’ve made almost 5%, while owning the world (or at least a pretty big part of it) would have cost you more than 10% of your investment.

So, do you put all of your eggs in a 30 stock basket for next year or should you continue to invest globally? If next year exactly mimics this year the answer is obvious. Is it likely? No! Do you know what’s going to happen to every stock market on the entire planet next year? Don’t kid yourself.

Now, let’s broaden our perspective a bit. Using the same 3 indexes, decide which would have been a better point of reference, for a well diversified portfolio over the past 10 years.

From January, 2002 through December, 2011 the Dow Jones 30 Industrials Average rose by about 22%. Standard & Poor’s 500 stock index only grew by about 9% over those same 10 years. Meanwhile, the broader DWG index rose from 1734 to 2343, increase of almost 35%. This is due to the fact that, while the US market foundered for most of the last decade, many European, Asian, and Latin American markets flourished.

In the past year, those same foreign markets have not fared as well as the US market. Given the longer-term performance international markets, it would be foolish to remove them from a portfolio based on a single bad year. Almost as foolish as it would’ve been to bail out of the US market in late 2008 or early 2009 (when the S&P 500 was worth about half of what it is today).

We continue to strongly believe in broadly diversified global portfolios. To help you maintain your long-term perspective, it is critical that you make sure you are making proper comparisons. Comparing a globally diversified portfolio of over 15,000 stocks to the Dow 30 is worse that comparing apples to oranges. It’s more like comparing apples to the entire produce department.