Why Your Portfolio Didn’t Beat the Dow

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

This entry was posted on Jan 25, 2018 3:31:09 PM

and tagged Commentary

Leave a comment

DowWhen investors look at their final statements at year-end, there is bound to be lots of discussion about how their portfolios performed. And, as has become usual in the past couple of years, there will be questions about and comparisons between the U.S. stock indices and that performance. In other words, how can the Dow or the S&P be up by that much and I am “only” up by X?

Admittedly, I added the quotation marks there. But it is a real and valid question. What it gets to, though, is a deeper question beyond how your investments did this year: what should we expect from our investments—and why?

Let’s start with the past year

If you held only the Dow Jones Industrial Average (DJIA), you would have been up by 28 percent, the Nasdaq by almost 30 percent, and the S&P 500 by “only” 21 percent. If you held the most common bond index, the Bloomberg Barclays U.S. Aggregate Bond Index (the Agg), you would have made about 3.5 percent. A 60-percent stocks/40-percent bonds allocation between the S&P 500 and the Agg, which is a reasonable shorthand for a balanced portfolio, would therefore have returned about 14.5 percent.

That balanced return, at 14.5 percent, is a heck of a lot less than the stock indices. Why should we settle for that? Perhaps we should invest only in stocks or at least put more in stocks. That would certainly generate higher returns. So, why aren’t we taking more risk? This is becoming a more common discussion as stocks rise higher and higher.

Why stop there?

If that is the plan, though, why stop there? The MSCI Emerging Markets Index was up almost 38 percent in 2017. If we are focusing only on return—and only on the last year—we should be fully in emerging markets. This is the logical conclusion of the argument that we should put more money in stocks.

It is, however, crazy talk. In any given year, stocks are likely to outperform—but not always. The S&P 500, for example, has done very well over the past couple of years, but it has also periodically done quite poorly. And, of course, if you include 2000 and 2008, it is clear there is very real risk that goes with those high returns. You see the same thing with emerging markets, with high gains in some years and heart-stopping declines in others. You never know which it will be. Focusing on the asset classes with the highest returns can also result in the largest losses, as we have seen over and over again.

Diversification rather than focus

The answer to this problem, of course, is diversification instead of focus. By spreading your bets around, you are less exposed to the standout investments but also less damaged by the bad ones. You will make less and lose less. Over time, your returns will fall within a narrower range. You can see that in the chart below:

Dow
Source: Novel Investor

Note how the light-gray box, the asset allocation (AA) diversified portfolio, is never the best performer. But it is also never the worst.

One caveat

For most people who are focused on achieving their goals in a disciplined way over time, this is the right road. Unfortunately, however, there is one very real caveat: you will never (never!) match the best performers out there. In that sense, you are condemned to underperform. On the other hand, you are also guaranteed to outperform the worst performers.

So, the answer to the question “why did I underperform the indices?” is therefore quite simple—by design. To avoid the price declines we know happen, you have to underperform the best performers. Mathematically, it has to be that way.

Keep an eye on the destination

Over time, a diversified portfolio is not only easier to live with but also a better investment solution. It certainly doesn’t make it any more tolerable to see the indices growing that fast, though. When I am driving on the highway, it is maddening to see people blowing by me in the fast lane. But now that I’m older, I stay focused on the destination—as well as the very real chance those drivers may crash—and just keep going the speed limit. Well, close to it anyway.

Subscribe via E-mail

New call-to-action
Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®