Everyone loves to compare. Physicians are especially prone to comparing themselves to others. After every medical school exam, the first question out of most students’ mouths is, “What was the average?” followed by “What score did you get?” Physicians have been in the 99th percentile for their entire academic lives. We also are driven in our athletic, artistic, and parenting activities. We want to be the best at these things, too.
So it’s not surprising that we like to compare our investment returns against others. Many personal finance bloggers, including Physician On Fire and Some Random Guy Online, have posted their 2016 investment returns. The Big Law Investor was critical of the Harvard endowment for underperforming the S&P 500. Mutual funds will report their investment returns alongside that of a benchmark index.
As an index fund investor, which index should you use to compare your returns? Is it necessary to benchmark your returns at all?
By far, the most commonly used benchmark used by the financial media and investors is the S&P 500. This is the most well-known index among investors. It has been around since the 1920s. Investors around the world use the S&P 500 to track the performance of U.S. stocks. The Dow Jones Industrial Average is another well-known index that is commonly used to benchmark.
However, the only mutual funds that should use the S&P 500 as a benchmark are large-cap mutual funds. Investors should hold both stocks and bonds. Even if they hold 100% stocks, they may hold a portfolio of large, medium, and small companies, while the S&P 500 only contains large-cap stocks.
As an alternative, many mutual funds will benchmark their returns against an index that matches their investment style. For example, many bond funds may benchmark their returns against the Barclays US Aggregate Bond Index. Small-cap mutual funds may compare their returns to the Russell 2000. Hedge funds may compare their returns against other hedge funds with similar investment philosophies.
For investors with a diversified portfolio between stocks and bonds, Wealthfront states that a 60/40 stock/bond portfolio consisting of the S&P 500 and the Barclays US Aggregate Bond Index is the most common benchmark for diversified portfolios. While this would be an appropriate benchmark for investors with a 60/40 stock/bond asset allocation, it is not a good benchmark if the investor holds a 90/10 or 30/70 stock/bond portfolio.
Does the Index Fund Investor Need to Benchmark?
As index fund investors, we don’t need to benchmark our returns against a major index. What is the point? If we hold an S&P 500 index fund, why do we need to compare its return against the S&P 500? For our bond allocation, if we already hold AGG, an exchange-traded fund that tracks the US Aggregate Bond Index, what is there to benchmark? By investing in index funds, we are able to match the benchmarks everyone else uses to compare.
An Alternative to Benchmarking
Instead of comparing your returns to a benchmark index, focus on the following factors:
- Am I investing in low-cost index funds? Keeping costs low is a free lunch in investing, so be sure that you are investing in index funds with low expense ratios. There is no need to switch from one S&P 500 index fund to another S&P 500 index fund that has a lower expense ratio by 0.01% or 0.02%. But if you hold several actively managed funds, you should work to sell these funds in favor of low-cost index funds.
- Is my portfolio diversified and appropriate for my risk tolerance? Check whether your portfolio has the right asset allocation for your risk appetite. Your portfolio should consist of a mix of U.S. stocks, international stocks, and bonds. Rebalance your portfolio when your asset allocation significantly changes.
- Did I minimize taxes by not trading within my taxable account? Trading in your taxable account can be very expensive. By paying taxes on profits in your taxable account, you reduce after-tax returns. I recommend keeping investments in your taxable account very simple, ideally with a single stock index fund or target-date fund. You can experiment with more exotic asset classes in your retirement accounts, where frequent buying and selling do not have tax consequences.
Accepting average returns is very difficult for physicians. We are used to being superlative in everything we do. However, by reducing fees and taxes by using index funds and minimizing trading, you end up performing far better than the average investor.
What do you think? Did you compare your portfolio returns to an index last year? If so, which benchmark did you use?