5 reasons why comparing your portfolio to an index doesn't work

financialpost.com:

Many market indexes hit new highs this week, but have you ever really thought about a stock index? What it is exactly, and why are they so important (if at all)?

A stock market index is meant to show how a market is doing on average. It typically includes the largest companies in a country, and there are 11 different sub-sectors in North America. Committees try to set up their indexes so they represent the economy/market. If a company is taken over, a new company is added. If a company’s shares become too illiquid, it is dropped from the index.

Most indexes have highly regulated criteria. For example, the S&P 500 has, amongst others, the following criteria for any company to be added: its shares must be highly liquid; at least 50 per cent of its outstanding shares must be available for public trading; it must report positive earnings in the most recent quarter; and the sum of its earnings in the previous four quarters must also be positive.

But watching an index too closely, and comparing it to your own investment portfolio, may not be right for every investor. Far too much emphasis is put on beating the index. We understand this focus if you are a professional fund manager. After all, portfolio managers need to justify their fees, and if they can’t beat the market then what are you paying for? But for individuals, let’s look at five reasons why there is far too much focus on index returns.

If you are comparing any index to your own returns, the index composition needs to match your portfolio’s composition. Otherwise, the comparison will be largely meaningless.

For example, the S&P/TSX composite index is currently 31 per cent financials and 17.7 per cent energy. If you want more diversification and don’t think two