Fake News and Financial Markets

From the title of this article, you might think that I will be discussing how “Fake News” in the broader media impacts the markets. But there is another kind of fake news.  If you don’t understand it, you will be in a world of trouble come the next correction or recession.

What could I possibly be talking about. Market index performance. Yes the Dow Jones, the S & P 500, the Nasdaq 100, the Russell 2000. I could go on and on.

When meeting with the families we help, the conversation will often turn to how did my investments compare to the markets. Let’s take the S & P 500 for example. A group of 500 stocks that is believed to represent a well diversified large company portfolio. It seems reasonable to compare the returns of the S & P 500 to your equity portfolio. But it isn’t.

Here is why. It’s called capitalization-weighting. Without getting too technical it means, the larger the company the more it counts. The reality is that Amazon, Microsoft, Apple, Netflix, Facebook and Alphabet (Google) represent almost all the investment returns for the S & P 500 YTD. So what about the other 494 stocks. Not so much.

While this is great when these tech/internet/entertainment companies are doing well, what will happen to the indexes when just these stocks hit a road bump, like new regulation or privacy concerns or cyber terrorism.  

Portfolio returns are driven by the types of investments within the portfolio. If you are invested solely in the total market or the S & P 500, then your performance would likely be driven by a handful of stocks. This is simply the way market cap weighting works. This is why passive investing does well in up markets but no so good in down markets.

On the other hand, having a diversified portfolio and using active managers outside of the market cap-weighted indexes provides greater diversification.  

While this may result in a lower upside, it also can have the impact of limiting the downside. This means lower volatility which is a key to having a successful, financial secure retirement.

The moral of this story is….beware of fake news. To truly understand your investment strategy, you need to dig deep into not just what the performance is for a particular index or portfolio but what are its drivers in good times and bad.