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Benching the Mark

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By wax
September 15, 2004

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I was asked the other day if I benchmarked my personal portfolio against an index. The answer is no I don't, and the reason I don't is because I can't find an index that resembles my portfolio.

The index most widely used for comparison is the S&P 500 Index. Every investment firm compares their performance to the performance of the S&P 500. But how can you compare a benchmark index to an individual portfolio unless your portfolio has the same stocks, or the same make-up of stocks as the index it's being compared against?

In trying to figure out if there was perhaps an index that I could use to benchmark my portfolio against, I decided the best thing to do would be to get some understanding of just what the S&P 500 Index is.

First things first I guess, and in this case you need to know that McGraw-Hill, Inc. (MHP) owns Standard and Poors, which is the company that employs the people that oversee more index funds than I could count. And yes Elizabeth, I tried to count them all!

As I said, the index that seemingly every individual investor and every investment firm wants to beat is the S&P 500 Index. This index is made up of 500 of the "leading companies in leading industries of the U.S. economy."

The index focuses on "the large-cap segment of the market, with over 80% coverage of U.S. equities...". The first part of that I understand, the second part, not so well. I mean maybe I should get out more, but it just seems hard for me to believe that 80% of the public companies in the US are large-cap companies. Maybe that's right or maybe that's not what those words mean. As I say, I'm not sure.

The index is also billed as "...the best single gauge of the US equities market...". Again, maybe that's true and maybe that's not true, I personally have no idea, since I only own some stocks that are IN the US equities market. It would be sort of cool though to own the entire US equities markets. I mean every share of every company. Wow!

The S&P 500 Index is also "cap" weighted, meaning the bigger companies have a higher weighting, so a good year from a few of the bigger companies in the index can make the overall index look great when the majority of the companies actually had a poor year.

The reverse is also true, a poor year by a few of the bigger companies in the index can make the overall index look as if it had a bad year even though the majority of companies had a good year.

The other thing that really bothers me, and maybe I need to change this, is I don't have 500 stocks in my portfolio. I do however have about thirty (30) stocks, or 6% of the number in the index. Seems sort of strange to compare my portfolio to a portfolio that has 94% more stocks in it than mine does. I mean what is faster, an Indy racecar or a Saturn V rocket? Heeeeelllllllllooooooooooo!

At any rate I don't think the S&P 500 Index is a good comparison for my portfolio, but perhaps one of the other index funds will be.

Here's one, the CBOE S&P 500 BuyWrite Index (BXM). This index is "designed to track the performance of the hypothetical buy-write strategy on the S&P 500 Index." Not only do I not have any idea what that means, I really don't have any desire to find out what that means.

Here's another one, the CBOE Volatility Index (VIX). This index is a key measure of market expectations of near-term volatility conveyed by S&P 500 index options prices. This doesn't sound very straightforward to me, so I doubt I would understand it. It also doesn't sound like something I could use as a benchmark for my portfolio. Maybe it will work for yours.

Let's see, there's the S&P Equal Weight Index (S&P EWI). This is the same index as the S&P 500, except that it's rebalanced quarterly and each stock is allocated a fixed weighting of 0.20%. Since this index doesn't sound too much like mine, I don't think it's of much use as a benchmark for my portfolio. I do like that the index is rebalanced, even if that rebalancing is done far too often to suit me, and I like that all of the stocks have an equal weighting.

Here's one you probably never heard of, the S&P 500 O-Strip Index. This index is made up of companies from the S&P 500 Index that trade on the NASDAQ. Since I have very few NASDAQ stocks this one also doesn't seem to hold much value as a benchmark for my portfolio.

Let me see. Oh, there's the S&P MidCap 400, made up of 400 companies from the US equities markets. According to the web page, this index covers about 7% of the US equities market. While the percentage is closer to what's in my portfolio, the number of stocks isn't even close.

Here's the S&P SmallCap 600, made up of 600 companies from the US equities markets, which supposedly covers about 3% of the US equities market, and here's the S&P Composite 1500, which combines the S&P 600, 500, and 400 into one index fund. Do you know anybody that owns 1500 individual equities? I know I don't.

In addition to these indices, there are the S&P 1000, the S&P 900, the S&P 100, and the S&P REIT Composite. There are also lots of other indices but just like these, those indices aren't representative of my portfolio either.

So you ask, if I don't compare my portfolio to an index of some sort, what do I compare it to? The answer is itself, and only then if I remember, which admittedly I usually don't. All I know is that on some arbitrary date, I looked at my portfolio balance and it was "x" and then on some other arbitrary date I looked at my portfolio balance again and it was "y". Hurray for me

The bottom line, at least to me, is comparing individual portfolio performance to an index that doesn't come close to representing an individual portfolio is for SAPS. That's what I said it's for saps.

I hear folks talking about how their portfolios beat the S&P by 55% or 92% or whatever, and I think to myself not only are those folks saps, but so are the people that believe that trash!

It's been my personal experience that most folks that brag about beating an index don't even own any individual equities, that is unless Uncle Fred left it to them when he went to the great tuna fish farm in the sky. Heck, most of these saps think an equity is something you either get when you sell your house, or something you use to save for retirement!

So what's the point? Simple. On January 1st look at the value of your portfolio. The following December 31st look at it again. Subtract the January number from the December number and then back out all of the cash contributions you made. That's the dollar increase or (decrease) for the past year.

If you feel the need to compare it to something, then try comparing it to how many doughnuts you get when you buy a dozen doughnuts, then smile and think to yourself...Uncle Fred would be so proud.


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