This week’s question comes from Phil. Phil has been following the investment returns of his portfolio with much enthusiasm. He has similarly been watching the performance of the Dow Jones Industrial Average (DJIA), comparing the DJIA to his own portfolio. Given this investment portfolio comparison, Phil writes in to say:

I’m troubled by the fact that my portfolio is not producing the same return as the Dow Jones. Why is this happening? Why isn’t my portfolio of stocks, bonds and alternative investments matching the performance of the DJIA?

Phil’s question is a good one: Why isn’t his portfolio showing results similar to the DJIA? Before we answer Phil’s question, let’s discuss what the DJIA is.

[h2] Dow Jones Industrial Average[/h2]

The DJIA measures the investment return of a very select group of companies’ stocks – just 30 in total. All of the companies in the DJIA are large capitalization domestic stock. In plain English, this means that the DJIA is composed of 30 large United States companies. Many of these companies are household names, such as:

  • American Express
  • Chevron
  • AT&T

The DJIA is an index, or a benchmark. The DJIA is often used as a point of comparison – to evaluate the efficacy of a stock picker: a professional (or sometimes lay) money manager seeking to invest in only those companies that the money manager feels provide the greatest opportunity for investment return.

Balboa Park, San Diego, CaliforniaThe DJIA can be used to determine if the money manager is earning his keep (i.e. if the money manager/stock picker is any good). This is done by simply comparing the performance of the money manager’s stock picks to the investment return of the DJIA. If the stock picker is truly skilled, he/she may be able to select those specific companies that outperform the DJIA.

Does it Make Sense to do an Investment Portfolio Comparison with the DJIA?

Phil is using the DJIA as a benchmark for his portfolio. Does this make sense? Is this an appropriate investment portfolio comparison? Is it appropriate for Phil to compare the performance of his portfolio the DJIA? Maybe. It depends on what Phil’s portfolio is made of.

When would it not make sense to use the DJIA as a benchmark? It would not make sense for Phil to compare the performance of his portfolio to the DJIA if his investments include those outside the category of large United States companies. This is because the DJIA is composed solely of large United States companies.

Sweetwater River BridgeConsider: Does Phil have money invested in Toyota – a foreign corporation? Or does Phil own shares of Realty Income Corporation – a real estate investment trust (REIT)? If Phil is invested internationally, or if he is invested in real estate, he may be making an apples-to-oranges comparison when benchmarking his portfolio to the DJIA. This is because, as mentioned, the DJIA is an index composed exclusively of large United States companies.

[h2] If not the DJIA in an Investment Portfolio Comparison, then what?[/h2]

If you’re making an investment portfolio comparison, know that the DJIA is not the only index in existence. There are countless indices available. Another common index is the S&P 500. Unlike the DJIA, the S&P 500 invests in not 30, but 500 large domestic corporations. A broader benchmark, like the S&P 500, may be marginally more appropriate as a point of comparison.

There is an even more comprehensive index, the Wilshire 5,000, which tracks the performance of the entire domestic stock market, i.e. all United States companies. However, despite its breath, even the Wilshire 5,000 can fail as an adequate benchmark; the Wilshire 5,000 can be inappropriate as a benchmark when a portfolio includes foreign corporations.

Coronado Beach Sunset

If a portfolio is composed of globally diversified equities, consider choosing the Financial Times Stock Exchange (FTSE) Global All Cap Index as a benchmark. The FTSE Global All Cap Index includes both domestic and foreign companies. This index tracks the performance of company stock of all sizes, from all over the world.

[h2] Making an Investment Portfolio Comparison with a Diversified Portfolio[/h2]

When it comes to making an investment portfolio comparison, the issue of finding the right benchmark may be moot. Consider that many modern portfolios contain a variety of distinct types of investments. (In investment geek speak, distinct types of investments are called asset classes.) A diversified portfolio can contain any number of distinct asset classes, including:

  • Small Capitalization Domestic Equities
  • Emerging Market Economies
  • Commodities
  • Cash
  • Municipal Bonds
  • Treasury Inflation-Protected Securities
  • Corporate Bonds
  • Nominal Government Bonds
  • Government-Related Bonds
  • Foreign Government Debt
  • Emerging Market Debt

[h2] Why so Many Different Types of Investments (Asset Classes)? [/h2]

Why would anyone want to (and why do we at Wealth Analytics) invest in so many different things – so many different assets classes? Modern Portfolio Theory – the predominant investment philosophy – makes the case that investing in assets with distinct performance allows us to build portfolios that exhibit equal performance for less risk.

Balboa Park, San Diego, California

One diversified portfolio for retail investors, as suggested by the Chief Investment Officer of Yale’s Endowment David Swensen, includes a variety of asset classes. It is showcased below.

swensen portfolio

[h2] Answering Phil’s Question[/h2]

How should Phil make his investment portfolio comparison? Let’s return to Phil’s question:

Why is my portfolio not producing the same results as the Dow Jones?

Phil’s portfolio is showing different numbers than the DJIA because Phil is invested in a broadly diversified portfolio of global stocks, bonds and alternatives. While he may not see the same numbers as the DJIA, Phil’s broadly diversified portfolio can help reduce Phil’s exposure to risk. In short, his portfolio is showing different numbers than the DJIA because his portfolio is less risky than the DJIA. Since Phil’s portfolio is so well diversified (relative to the DJIA), comparing the performance of his portfolio to the DJIA would be an apples-to-oranges comparison.

More importantly, Phil is asking the wrong question entirely. Instead of asking, what is my return relative to the DJIA, Phil should be asking:

What is my risk?

More specifically, Phil should be asking:

What is the return I’m getting for the risk that I’m subject to?

In next week’s post, we’ll talk about why people often ask the wrong the questions – and why they focus on return, when they should instead focus on risk management.

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If you’re unsure of how to evaluate your portfolio – or would like an analysis of your existing investments – work with a fee-only financial planner to help you evaluate the performance of your assets. A fee-only financial planner can help you with your own investment portfolio comparison.
[subtitle2]References[/subtitle2]

S&P Dow Jones Indices LLC. (2014). Dow Jones Averages | Dow Jones Industrial Average | Overview. Retrieved from S&P Dow Jones Indices » Welcome: https://www.djaverages.com/?go=industrial-overview

Barclays. (2014, September). Barclays – Index Products – Government Bonds. Retrieved from Barclays – Index Products – Home: https://index.barcap.com/Benchmark_Indices/Government

FTSE Group. (2014, September 30). FTSE Factsheet: FTSE Global All Cap Index. Retrieved from FTSE: www.ftse.com/

Swensen, D. F. (2005). Unconventional Success: A Fundamental Approach to Personal Investment. New York, NY: Free Press.

Wilshire Associates Incorporated. (2014). Wilshire Associates. Retrieved from Wilshire Associates: http://web.wilshire.com/Indexes/Broad/Wilshire5000/

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