Why an obsession with the S&P 500 is unhealthy for individual investors
It’s understandable for investors to ask, how is my portfolio doing?. When the average investor thinks about how the market is performing, the S&P 500’s year to date performance might be the statistic that first comes to mind. Naturally, it is common for investors to then compare the performance of their portfolio to the S&P 500. The tendency to compare their portfolio performance to the S&P 500 is more often than not both inappropriate and counterproductive for individual investors. Unlike a large cap stock mutual fund where the comparison may be valid, individual investors have specific goals, objectives, and risk tolerance considerations. So, if this is inappropriate, what should they focus on instead?
If not the S&P, what’s the right question?
Constructing a portfolio requires considering a client’s goals, objectives, and risk tolerance. Instead of asking, how is my portfolio performing relative to the S&P, the right question might be, is my portfolio allocation still appropriate for meeting my goals, objectives, and risk tolerance? More recently, comparison to the S&P 500 is a function of performance chasing as equity markets have risen substantially over the last decade. An investor in the S&P 500 between April 1999 and August 2010 would have lost nearly 4%. If this same investor had “beaten” the S&P 500 by losing “only” 2%, would they feel better? Comparing your portfolio to S&P 500 in rising markets, and your own risk tolerance in down markets is an unrealistic expectation. Point being, relative performance to the S&P says nothing about whether an investor is meeting their goals and objectives.
Diversified client portfolios typically own a mix of US equities, International equities, investment grade fixed income, and non-investment grade credit among other asset classes. The S&P 500, which is essentially the largest ~500 US companies by market cap, is only a portion of the investable market. Other asset classes beyond this are typically incorporated in order to provide diversification benefits, lower volatility and to meet specific goals and objectives. Losing sight of this can lead an investor into an allocation that chases performances, and may ultimately entail more risk than their financial plan deems necessary.
Set it and forget it
Some investors may counter that the best investment strategy historically has been to invest in a S&P 500 index fund and forget about it. So why shouldn’t they do that? As we’ve discussed above, very few people have goals and objectives that line up with a 100% S&P 500 allocation.
Just for fun, let’s assume we’re talking about an investor who does have a long time horizon, no liquidity needs and a high willingness and ability to tolerate large drops in value. In this case, would a 100% allocation to the S&P 500 make sense? It is said that a good investment strategy is one that makes sense and that you can stick with. In my experience, few investors are willing to sit through the extended draw-downs of a 100% stock portfolio. While it sounds good in theory, it’s very impractical due to the psychological factors that investors endure. Fear and greed are real impediments. Sticking with such an allocation in the midst of perceived panic is different than looking at a multi-decade chart and concluding that a buy and hold strategy would’ve been most optimal. Remember, it’s not that investors are typically irrational, it’s just that they tend to make irrational decisions at the worst possible time.
What’s the net-net?
Except for rare instances, it will be imprudent to compare an individuals’ portfolio performance to the S&P 500. Ultimately, this tends to be counterproductive by focusing on one segment of the market instead of whether a client’s allocation is practical for meeting their goals and objectives. This is not to say portfolios, or portions of the portfolio, shouldn’t have a benchmark comparison (something we’ll evaluate in a subsequent blog piece), but the default comparison to the S&P 500 is the first thing that should go.