Situation Analysis

Situation Analysis

Why Chasing a Benchmark Index Can Hurt Investment Performance

Why Chasing a Benchmark Index Can Hurt Investment Performance

It seems that, as this historic bull market continues to climb to new heights, investors are becoming more obsessed with their portfolio returns. For many, it’s not enough that the stock market has been delivering double-digit returns; they are now focused on the market benchmarks, such as the S&P 500 or Russell 3000 index, and whether their own portfolio returns are measuring up to the benchmark returns. As the stock market continues to hit new highs, the fear of underperformance is driving an unhealthy fixation on benchmark comparisons. It’s unhealthy because benchmark returns have little to do with investors’ personal investment objectives and the fear of underperformance could lead to harmful investment decisions.

Benchmarking Can Actually Lead to Underperformance

While benchmarking can be useful for a historical perspective, it can be a distraction when used as a means of gauging investment performance. The real target for investors should be their own investment objectives. In a study by Dalbar Inc., it was revealed that, when investors make investment decisions based on the short-term returns of the market, they increase the likelihood of making behavioral mistakes that hurt their portfolio’s long-term performance. Mistakes like chasing performance, or trying to time the market, or following the herd during times of exuberance or panic, unnecessarily increase risk and investing costs, which leads to underperformance. Their research clearly shows that investors who base their investment decisions on past performance consistently underperform the market.

Long-Term Investors Should Ignore the Hype

The Dalbar study also found that investors who constantly scrutinize their account statement are more likely to want to compare their returns to the market benchmarks and think more often about tweaking their portfolios. Investors who make frequent adjustments to their portfolio invariably underperform the market. And those who fixate on the commentary of the financial pundits tend to follow the erratic movements of the herd, especially in reaction to short-term market or economic events – and the herd is almost always wrong.

Keep Your Eye on the Real Target

If investors focus instead on the more critical benchmarks – their own investment objectives established through thoughtful planning – they will find they can achieve more stable and consistent investment performance over time. When used as benchmarks, investment objectives are more concrete and meaningful than a benchmark index that has no bearing on whether you achieve your financial goals.

Think of it this way: You establish a retirement goal with a 20-year time frame that requires an average annual, risk-adjusted return of 8%. You construct your investment portfolio around a risk-return profile that will achieve that over the long-term. Should it matter to you whether the Russell 3000 index gains 25% this year and loses 25% next year? Your portfolio is constructed based on the required return of 8%, not an unknown benchmark return you can’t control. If your portfolio performance stays on track to achieve your required return, then why distract yourself with the meaningless, short-term fluctuations of the market?

 You Need an Investment Strategy

The biggest reason why investors are easily distracted by the short-term fluctuations of the market is they don’t have a comprehensive financial plan with a well-conceived investment strategy. As opposed to being goals-driven, their investment decisions are often market-driven or risk-driven, which is a reactive rather than proactive approach to investing. It also leads to hesitation and second-guessing, which can lead to underperformance.

With a sound investment strategy, investors are more likely to stay focused on their long-term investment objectives, rather than meaningless benchmark indexes. It’s the strategy that keeps them grounded in risk management principles that guide their asset allocation. But, most importantly, investors who strictly adhere to a long-term investment strategy are able to ignore the irrational behavior of the herd in response to market or economic events.