What You Really Need to Focus On As an Investor

Let's face it: We all love to compare ourselves with others, especially if it makes us look good. However, when it comes to investing, comparing your portfolio with a benchmark and trying to beat the market focuses the attention on relative success rather than a definitive long-term goal. And since the market is an amorphous thing that you have no control over, using it to evaluate your portfolio can be perilous.

Consider Garrison Keillor, host of radio show "A Prairie Home Companion," describing Lake Wobegon as "a place where the women are strong, all the men are good looking and all the children are above average." Of course, the simple assertion that all the children are above average ties into our hope and desires for our children and so on. Yet we all know that the average is made up of everyone, and someone has to be below average.

Everybody wants to be above average, and no one wants to be below average. At the same time, successful people know the world is made up of all types and levels. Someone or something that is below average at one time can be above average at other times, depending on who or what are being compared.

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When they think of benchmarking, many investors think of the market—often the Dow Jones industrial average or Standard and Poor's 500-stock index, specifically. Yet these indexes are just a tiny fraction of the 44,000 listed stocks globally. Yes, they have made up a significant portion of global market capitalization. However, the exposure is still quite limited. Plus, these benchmarks do not remotely consider the even larger universe of non-traditional investments that can potentially add value in multiple ways.

Are investors using benchmarks effectively, and do they compare the right things? Recently the London School of Economics and the Paul Woolley Centre released a paper entitled "Curse of the Benchmarks." In the abstract, the paper starts out with the following: "Obsession with short-term performance against market cap benchmarks preordains the dysfunctionality of asset markets. The problems start when trustees hire fund managers to outperform benchmark indexes subject to limits on annual divergence. For multi-asset portfolios, the benchmark is generally the performance of peer group funds, also based on market cap. In the absence of formal instructions, asset managers, as well as off-the-peg mutual funds, are still keen to demonstrate their ability against the competition in the short run."

In other words, manically following a benchmark or benchmarks encourages compliance with that standard. The behavior potentially ignores the larger objective or, even worse, leads to investing in expensive "closet indexers." This also may encourage implementing higher-risk strategies in an attempt to not stray too far from the artificially set objective and still try to add value.

To be clear, comparing your portfolio with established benchmarks can be instrumental for a portion of your evaluation. You just have to be sure to use the right benchmark for you. While the market is a commonly used measure, it may not be the best in evaluating your specific portfolio. In the Morningstar database, there are more than 70,000 different indexes to choose from—clearly way too many for most investors to effectively use.

Yet is the most important question for evaluation which of these indexes to use? Or is it whether your portfolio is meeting your individual and family goals and objectives? Is your objective to preserve wealth on an inflation-adjusted basis? Or is it to provide an inflation-adjusted cash flow to meet current and future needs? Or is it to grow wealth at some nominal return plus inflation? From my humble perspective, the more concrete, broader objectives seem to provide a better goal to shoot at than attempting to beat the market.

Bob Klosterman, CFP, is the Chief Executive Officer and Chief Investment Officer of White Oaks Investment Management, Inc., and author of the book, The Four Horsemen of the Investor's Apocalypse.