Sam Ro, via Business Insider, wrote a very interesting piece last week discussing the “roller-coaster ride stock market investors must be willing to endure.” To wit:

“Historically, the stock market has been able to deliver around 10% annual returns on average. The key word when thinking about that, however, is ‘average.’ Rarely will you ever see the S&P 500 climb an even 10% in a given year. This 10% is determined by averaging years that have experienced returns much better than 10% as well as years that are much worse or even negative.

Bank of America Merrill Lynch’s Savita Subramanian shared a chart that does a pretty nice job of illustrating the roller-coaster ride that stock market investors actually experience. She reviewed 12 major S&P 500 peaks since 1930 and averaged the price performance during the months leading into the peak and the months after.”

While Sam is absolutely correct in his article, there are a few very important things that must be considered by individual investors before “jumping off this particular cliff.”

Most importantly, the analysis above fails to consider the impact of inflation, fees, and expenses on returns over time. This is something I will discuss more in a moment. Most importantly, what is also not addressed is the effect of “TIME.” While 10% annualized returns sound fantastic, that was over the course of more than 100 years and included an average dividend yield of almost 4%. Unfortunately, you will not live long enough to realize those “average rates of return.” 

I want to specifically address the fallacy of chasing a benchmark index (i.e. the S&P 500.) The continual chase to “beat the benchmark” leads individuals to make emotional decisions to buy and sell at the wrong times; jump from one investment strategy to another, or from one advisor to the next. But why wouldn’t they? This mantra that has been drilled into all of us by Wall Street over the last 30 years. While the chase to “beat the index” is great for Wall Street, as money in motion creates fees and commissions, most individuals have done far worse. 

The annual studies from Dalbar show the dismal truth, individuals consistently underperform the benchmark index over EVERY time frame.

The reason this underperformance consistently occurs is due to emotional mistakes and the many factors that affect a “market capitalization weighted index” far differently than a “dollar invested portfolio.” 

Let’s set aside the emotional mistakes for today and focus on the differences between a benchmark index and your portfolio. 

Building The Sample Index

Before I can build a sample index it is critical that you understand how the S&P 500 index is constructed. The following explanation is from Investopedia:

“The S&P 500 is a U.S. market index that is computed by a weighted average market capitalization.The first step in this methodology is to compute the market capitalization of each component in the index.

This is done by taking the number of outstanding shares of each company and multiplying that number by the company’s current share price, or market value. For example, if Apple Computer has roughly 830 million shares outstanding and its current market price is $53.55, the market capitalization for the company is $44.45 billion (830 million x $53.55).

Next, the market capitalizations for all 500 component stocks are summed to obtain the total market capitalization of the S&P 500, as illustrated in the table below. This market capitalization number will fluctuate as the underlying share prices and outstanding share numbers change.

In order to understand how the underlying stocks affect the index, the market weight (index weight) needs to be calculated. This is done by dividing the market capitalization of a company on the index by the total market capitalization of the index.

For example, if Exxon Mobil’s (XOM) market cap is $367.05 billion and the S&P 500 market cap is $10.64 trillion, this gives Exxon a market weight of roughly 3.45% ($367.05 billion / $10.64 trillion). The larger the market weight of a company, the more impact each 1% change will have on the index.

For example, if Exxon Mobil were to rise by 20% while all other companies remained unchanged, the S&P 500 would increase in value by 0.6899% (3.45% x 20%). If a similar situation were to happen to The New York Times, it would cause a much smaller, 0.0076% change to the index because of the company’s smaller market weight.”