This Bloomberg article, which includes this amazing chart, caught my eye earlier this month:
As the pressure increases on the investment industry to get cheaper, more managers are turning to the ETF space for lower cost vehicles. As I wrote here before, it’s not always the case, but generally the money is flowing into ETFs because they are cheaper than traditional active mutual funds.
The most commonly known index is the Dow Jones Industrial Average, it’s the one you see on your nightly news. An index is just a way to track a basket of stocks, and for generations there weren’t many additions to the mix. As the graph shows, in the last few years the investing world has invented thousands of indexes, and it’s no accident it’s happened alongside a similar explosion in ETFs.
What’s this mean to you as an investor? Let me back up a bit…
Ask anyone that manages money for a living, and they’ll tell you they’ve had a version of this conversation:
Client: I noticed on the news the market hit an all-time high, it’s up 10% this year! Why is my portfolio only up 7%?
Advisor: Well the ‘market’ in this case is the Dow Jones, which is just 30 of the largest US companies. Your portfolio is more balanced and includes international holdings, bonds, etc.
Client: Can’t we buy some of the Dow stocks that are doing well? I want to be up 10%!!
Advisor: Well sure we could buy more of those, but you have told me previously that you prefer to take less risk so you don’t lose a big chunk of money when the market goes down.
Client: Yes that’s true, I don’t want to take a big loss like 2008.
In this small sample of conversation there are several typical behavioral investing mistakes at play.
First, ‘performance chasing’ is a commonly practiced form of investing for many. People see what’s doing well (often not based on their own study, rather they hear about it through TV, an article, their barber, Uncle Fred, etc.) and they buy it, discarding the things from their portfolio that aren’t doing well. Everyone understands that, by definition, to make money you must ‘buy low, sell high.’ Now there are nuances to this, but how well do you think you’ll do if you’re always buying the stock that everyone’s talking about, that’s in the news, and that has already gone very high? Yet people do it all the time, whether it’s impatience, FOMO, ego…no one can stand the idea that some other person is making 1 or 2% more than them, they want in!
Second – people love to take risk…but only when the market goes up. Over the years I’ve had so many conversations with people that are fearful of losing money, that don’t want to go backwards, etc., yet are upset when ‘the market’ is up 8% and they’re up 5%. Risk doesn’t work that way and neither does return. Another concept that everyone generally understands is that in order to achieve returns in investing, or even in life, you have to take some risk. In investing, most academic work considers a ‘risk-free’ return to be that of a US treasury note, because we all trust the country to pay its debt (insert joke here). Currently, a 10-year treasury bond will pay you 2.2%, that’s your ‘risk-free’ return. Want anything above that? You have to take risk, which means potential losses.
When you consider both of these behaviors, and really spend a few seconds thinking about it carefully, avoiding these mistakes just seems so logical. But we’re not dealing with logic, we’re dealing in emotions, and those are often as clear as mud.
That brings me back to this article, and indexes. If you started a mutual fund, you’d have to tell your investors what your benchmark was. Against what index will you be judged? If you own a bunch of things and you really want to know how it’s performing, you have to compare it to something for the number to be meaningful.
The problem with that practice? Your portfolio is extremely unlikely to look exactly like ‘the index.’ Or any index. It’s uniquely yours, it is unlikely to match your neighbor’s, or Uncle Fred’s, etc. A good, diversified portfolio is supposed to have exposure to many different categories of investments, countries, styles, etc. Each one of those categories has its own index, and its own benchmark. If it is properly diversified, again by definition, it can’t and won’t all go up at the same time!
Want to feel better about your finances? Stop worrying about other people, or an index. Stop looking over shoulders at what other people are earning, or buying, or spending. Resist the urge to leap the next time Uncle Fred gives you a hot stock tip. Only you can control your household finances, and your investments should always align to your goals, no one else’s. Try this exercise; What’s your ‘Personal Benchmark?’ A good advisor should be able to run the numbers and tell you a return scenario that fits your unique situation and will meet your goals. I discourage people from benchmarking to an index for this very reason – it’s not yours!
Yes, of course you want to do well and make smart investments. But if you run the numbers and you hit all of your goals with a 5% return on your money, and that 5% return is within a risk tolerance you can live with, well what else do you have to know? Does it matter what the Dow does if you’ve earned your 5% and met your goals? Of course not! So free yourself from the hamster wheel of keeping up with the Jones’, focus on your budget, your goals, and find your personal benchmark.