Why the S&P 500 is a Bad Benchmark for Your Investments

Imagine you are going to buy a house. How do you start the planning process? Do you look at everyone around you who is purchasing a home and do exactly what they do? Do you buy one at the same price point, the same size, in the same area, with the same mortgage company? Well, you could, but that would be pretty stupid.

No. You would first determine how much you could afford to pay monthly, investigate how much equity you currently have, research what neighborhood you want to live in, and find a mortgage that works for your situation.

It’s the same with your investment portfolio. Why would you compare your investments to a benchmark that doesn’t represent your finances as a whole?

The S&P 500 Doesn’t Work

If you subscribe to evidence-based investing, then your portfolio will be globally diversified and include low-fee funds with a unique-to-you asset allocation, tilted towards areas of better returns, such as small-cap stock (stocks of smaller companies). This creates a portfolio that is vastly different compared to the all-stock S&P 500 Index. So, comparing the S&P 500 with your portfolio — with the idiosyncrasies of your unique situation, including a healthy dose of bonds — won’t tell you much, at all.

I’m not throwing the S&P 500 under the bus. I’m just saying that you shouldn’t use it to gauge the success or failure of your personal investment portfolio. Here’s why:

It Doesn’t Give the Whole Picture

Let’s start with the basics: The S&P 500 contains the largest 500 American companies that are publicly traded. Think Google, Apple, and Disney. This gives it a heavy bias toward “large” companies, and they tend to be “growthy” (companies that are in the media spotlight and growing, and tend have a lot of built-up expectation to do well).

This does give the index a broad perspective of market performance and the US economy in general. But that’s just it…a generic picture doesn’t mean it applies to your unique financial situation. In fact, it could be completely irrelevant.

The media relies heavily on indexes to determine market success. We constantly hear about the S&P 500 or the Dow Jones Industrial Average in the news. On the internet, these indexes are front and center on most financial websites (and usually animated in some way to get your attention). So, with this ubiquitous, always-in-your-face nature of the S&P 500, it tends to be the default that most people use to analyze their portfolios.

Do You Diversify?

You should. And if you do, then don’t look at the S&P 500 as a benchmark. This index only contains stocks, and larger market cap U.S. stocks at that. Since your portfolio shouldn’t be 100% stocks, why compare the two?

A successfully diversified portfolio will include global investments, bonds, even cash assets. Diversification mitigates risk and helps when you rebalance. For example, when stocks have had a good run, rebalancing will force you to sell high (trim some of your winning stocks), and buy low (buy some bonds). This buy low / sell high routine is the core to successful investing, and having plenty of diversified assets to rebalance is a very good thing indeed.

Each asset class will have its own performance level. In fact, here’s a colorful “Asset Quilt” chart to visually show what I mean. So why compare your whole portfolio — with all its diversification, including bonds, cash, foreign holdings, etc. — to just one class?

When you invest, don’t you want to use the most apt comparison to make sure your money is where it should be and doing what it should be doing?

Then What Do I Do?

Since you shouldn’t use the S&P 500 as a benchmark, do you just let your portfolio sit tight and not analyze its performance? Of course not. But you need to compare apples to apples.

Instead, find an index fund that is similar to your portfolio in three areas: fees/cost, allocation, and diversification. Because of the thousands of possible benchmarks available, you should be able to find one to measure your portfolio’s performance against. Schedule a quick chat with me to find an appropriate benchmark for your situation. You may not find a perfect benchmark, but it will be a whole lot more accurate than the S&P 500.

Your first step is to know what you’re investing in and what’s happening with them. Use our powerful online portal to organize your investments and get a handle on your finances.

About Greg

Pathway founder and principal Greg Brown is a fee only financial advisor with broad financial planning and investing expertise. Greg’s financial advice has been featured in publications like Yahoo Finance, Bankrate, Investopedia (all articles here), Wall Street Journal, and USA Today. He holds a master’s degree from the University of Chicago and a mechanical engineering degree from Michigan State University. Prior to Pathway, Greg was a lead analyst at Morningstar and previously held engineering roles at Dell (including a US Patent).

Originally published at Independent Financial Advisor | Pathway.