Understanding the Limits of Index Comparisons
In the financial industry, there is a pervasive focus on benchmark-relative performance, particularly against the S&P 500. However, there is little education about how indexes are constructed, and this can lead to misleading comparisons. Indexes, unlike individual investments, do not incur fees or pay taxes. This makes it unrealistic to compare them directly to your actual investment experience.
Originally, indexes were developed as tools to evaluate the performance of active money managers in defined benefit plans. Today, investors often place undue emphasis on index performance which can skew investment decisions and lead to strategies that may not align with your personal financial goals.
Consider an investor who aggressively saved for retirement starting in 1998 with a top performing US Large Cap manager. If she outperformed the benchmark by 1% annually, she might still end up with a 0% annualized return over 10 years. Despite beating the benchmark, her outcome did not meet her retirement goals. From 1998 to 2008, a multi-asset approach could have yielded better results than a single index-based benchmark.
Markets are inherently unpredictable. While we can plan, we cannot predict future returns. For example, since 2014 US Large Cap stocks have outperformed most other asset classes. But from 2000 to 2018, emerging markets had the best performance. A diversified portfolio often provides a more consistent return pattern, which might better align with your goals, especially if you are actively withdrawing from your portfolio.
Source: Morningstar Direct, Indexes Represented: Cash: FTSE Treasury Bill 3 Mon, US Aggregate Bonds: BBgBarc US Agg Bond TR, High Yield: BBgBarc US Corporate High Yield TR, Emerging Market Bonds: JPM EMBI Plus TR USD, US Large Cap: S&P 500 TR, US Mid Cap: Russell Mid Cap TR, US Small Cap: Russell 2000 TR, Developed Ex US: MSCI EAFE NR, Emerging Market Equities: MSCI EM NR, Global REITs: FTSE EPRA Nareit Global NR USD, Commodities: Bloomberg Commodity TR, Liquid Alternatives: Wilshire Liquid Alternative TR
A common issue in investment reporting is the use of inappropriate benchmarks. For example, statements often only list the S&P 500 alongside the Bloomberg US Aggregate Bond Index, even when the investor’s portfolio is globally diversified and includes real assets. This is akin to comparing apples to oranges. The proper benchmark should align with your desired outcomes and goals, rather than relying on a generic index.
Focusing on Desired Outcomes
An outcome-oriented benchmark, such as aiming for a 4%, 5%, or 6% return, may be more meaningful to a long-term investor than simply trying to beat the S&P 500.
Success in investing should be gauged by the ability of your investment plan to meet or exceed your expected returns while managing risk to a level you can tolerate. This involves a careful balance between potential gains and the associated risks. To evaluate your investment strategy, ask yourself: What is the maximum amount of loss I am willing and able to endure in my portfolio while still securing enough returns to achieve my financial goals?
It’s essential to have a clear understanding of your financial objectives and risk tolerance. This means considering both your emotional and financial capacity to handle market volatility and downturns. Assessing your risk tolerance involves reflecting on your investment time horizon, income requirements, and overall financial situation.
Moreover, it’s crucial to align your investment choices with your personal values and long-term goals. For instance, if you aim for a comfortable retirement, ensure that your investment strategy supports this objective without exposing you to excessive risk that could jeopardize your future security.
Ultimately, a successful investment plan is not just about maximizing returns but also about maintaining a level of risk that allows you to sleep soundly at night. By carefully balancing these factors, you can create a portfolio that supports your financial aspirations and sustains your peace of mind through the ups and downs of the market.
Considering Taxes in Investment Planning
Taxes play a significant role in affecting investment returns. An outcome-oriented benchmark should consider returns after fees and taxes. Historically, success has been evaluated based on pre-tax returns compared to an index, which ignores the substantial impact of taxes. Each year, investors can lose a considerable portion of their returns to taxes. For example, as of 2022, taxes have decreased the return of the median large-cap active manager by more than 1% per year over the past 20 years.
This highlights the importance of considering tax efficiency in investment planning. By focusing on after-tax returns, investors can gain a more accurate understanding of their real investment performance. Tax-efficient investing involves strategies like tax-loss harvesting, selecting tax-efficient funds, and using tax-advantaged accounts, all of which can significantly enhance after-tax wealth growth.
Incorporating tax efficiency into your investment strategy not only helps in preserving more of your returns but also aligns your portfolio closer to your financial goals. By minimizing the performance drag caused by taxes, you can improve your overall investment outcomes and increase the likelihood of achieving your long-term financial aspirations. Therefore, it is crucial to prioritize after-tax wealth growth as a core component of your investment planning.
The Bottom Line
You cannot retire on a benchmark. This insight remains as relevant as ever. The key to successful investing lies in prioritizing personal financial goals over merely outperforming an index. By adopting a comprehensive approach that considers risk tolerance, tax efficiency, and diversification, you can create a robust investment strategy that supports your financial aspirations and provides peace of mind through market fluctuations.