What is an Index (or Benchmark)?
The term “Index” is widely used in financial conversations, publications and news broadcasts. Often the conversation goes something like “Investment X is outpacing the S&P 500 Index year to date”, however what does this really mean to the average investor? Indexes are the reflection of a segment of the financial markets such as: S&P 500, Dow Jones Industrial Average, Nasdaq Composite and Barclay’s Capital Aggregate Bond Index. These are only a very small sampling of the indexes available both Domestically and Internationally, what they tell us is the relative performance of the companies or bonds that they track. Due to the widespread nature of comparisons to the index that investors hear on the radio, television and in print it becomes an alarming commonplace for someone to want to know how they are doing against “the index”. This becomes the measuring-stick to success in many people’s eyes as a relative pass/fail on how they have done as an investor: beating the index brings feelings of satisfaction, matching the index many times creates a feeling of content, while under-performing the index produces an uneasy feeling. However, how do we know that everything we are saving and investing for depends on our relative performance to a market index? In the many years and countless financial plans that I have created for clients, performance relative to a market index was not part of our action steps to achieving that goal (e.g. the plans aren’t stating “beat the S&P 500 by 2% each year in order to achieve xyz goal”).
Benchmarks are the offset of using a broad-based Index as the line in the sand against and investment. A benchmark although very similar to an index is a hypothetical set of investments relative to your portfolio and/or investment you are comparing. As an example, an investor that holds a portfolio of 50% stocks and 50% bonds would not be making an equivalent comparison by using a stock index alone like the Dow Jones or the S&P 500 and therefore, benchmarks are created to show equivalent weightings in like investments for the sake of comparison. This becomes a more relevant tool for performance purposes allowing an investor to see if their allocation is keeping pace relative to the markets but it does not mean that the allocation that they hold is appropriate for their situation.
Why Aren’t Index or Allocation Benchmarks Enough?
When planning for your financial goals it is important to understand what you hold and why you hold it as an investor. Too many times allocations are birthed from an investor’s tolerance for risk rather than the potential for success or failure that the investments can create in someone’s most important goals. For this reason it has always been extremely important that we understand our client’s investment experiences (both firsthand experience as well as family investment experiences that they watched/learned from growing up), their core values and how these experiences make certain financial goals so important to them today. These steps let us more directly understand what is truly important to our investors and their families and have open discussions about perceived risk tolerance or investment return needs. For example, we will revisit the previously discussed 50% stock and 50% bond investor: How did they get there? If the answer was because they felt like they could only take “middle of the road risk” when asked to grade risk tolerance from 1-10 it could mean that they are only addressing a small part of the equation. Dependent on the person’s needs and savings they could potentially take on even less risk to reach the goals they want to achieve while not having nearly the same sized swings in portfolio values. On the other hand, this investor could also be unaware that in order to reach the goals they find most important they may need to save a little extra or work a little longer in order to stay in the 50/50 allocation that they hold. For these reasons we cannot feel confident in using just an index or just a benchmark to know if we are on the right path, only planning can do that for us as investors.
How Does Bench-marking to Your Goals Work?
Bench-marking to your goals involves and ongoing planning process. The first step is to begin by clearly defining your list of goals that you are looking to achieve and prioritizing these goals in order of importance. It also becomes important to understand how willing you are to take certain actions in order to achieve these goals that are being listed (e.g. an investor may be willing to work a little longer or save a little more to retire and be able to vacation at a certain interval whereas they may not be willing to take such actions for other goals.). Once goals are properly outlined and communicated planning allows an investor and the client the ability to look at multiple outcomes based off market conditions, withdrawal rates, taxes and inflation. This can show the average return needed to accomplish the stated goals as well as reflect on the goal commitments and necessary action steps. An ongoing partnership between investors and their trusted financial professional allows for ongoing support and bench-marking to continually assess progress to the goals that are most important while accounting for life events, market conditions and other changes that could cause goals to shift over time. At Coastal Wealth Planners we are able to track the outcomes of our planning and probabilities of success year over year while partnering with clients to ensure that we are seeing progress towards our goals. Too often investors can plan for a goal or a portfolio and not revisit where they stand in progressing towards what is looking to be accomplished. Over time this can lead to mis-allocations, improper risk tolerances, shortfalls in savings among many other considerations.
How to Get Started:
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