Who told you the S&P 500 is your benchmark?

benchmark4Dear Mr. Market:

Everyone wants to be associated with a winner. We are all familiar with the famous quote, “the thrill of victory and the agony of defeat” from ABC’s Wide World of Sports. Imagine that you are at a sporting event, you glance at the scoreboard but it shows nothing … at the end of the game you have no clue if your team won or loss. Some people claim your team won while others are not so sure. Mr. Market does exactly this to investors with their investment portfolios on a consistent basis.   As an investor how do you effectively gauge how your investment portfolio has performed and if you are victorious or humiliated in defeat?

The media would have us all believe that investors should use the S&P 500 or the Dow Jones Industrial (DJIA) as a benchmark against their portfolios. Turn on the nightly news or open a newspaper and you will quickly spot what each index closed at and what percentage they are up or down for the year. While everyone would agree that it’s important to have a sense of how the market is performing, is this the proper measuring stick investors should use to gauge how their own investments are performing?

A quick summary of the indices the media force-feed us on a daily basis:

Dow Jones Industrial Average (DJIA) – The Dow Jones Industrial Average is a price-weighted average of 30 stocks traded on the New York Stock Exchange and the Nasdaq.

S&P 500 – An index of 500 stocks chosen for market size, liquidity and industry grouping. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of large cap stocks.

Nasdaq – An index of more than 3,000 stocks mainly comprised from the Technology and Biotechnology sectors.

The issue that investors must be aware of is that unless their portfolio is extremely aggressive or concentrated in large cap stocks, the S&P 500 or DJIA are simply not a fair comparison. We’ve covered this topic numerous times – portfolio performance is driven by asset allocation and not by hot stock picks or timing the market. If you have a diversified portfolio then only a portion of your portfolio should be compared to these indices and neither of them account for: Mid-Cap, Small Cap, International, Emerging Markets, Alternatives and Fixed Income…. just to name a few!

If your goal is to beat the S&P 500 on a yearly basis and this drives either your advisor’s investment decisions or even your own, you could very well be on the road to disaster. You don’t have to look back far to find market environments where the S&P 500 delivered a variety of returns making a profound impact on a non-diversified portfolio.

S&P 500 Yearly Performance Results

2000 = -9.03%

2001 = -11.85%

2002 = -21.97%

2003 = +28.36%

2004 = +10.74%

2005 = +4.83%

2006 = +15.61%

2007 = +5.48%

2008 = -36.55%

2009 = +25.95%

2010 = +14.82%

2011 = +2.10%

2012 = +15.89%

2013 = +32.15%

2014 = +13.48%

If you invested your entire portfolio in the S&P 500 on the first trading day of January 2000 and didn’t touch it until December 31, 2014 you would have an annualized return of 2.095% when accounting for inflation and dividend reinvestment. What would you do with returns like this? Is it safe to assume you would either fire yourself or your investment manager very quickly?! With numbers like this why do people continue to look at the S&P 500 as the benchmark for their portfolio? If you take into account how the S&P 500 has done compared to other asset classes it becomes abundantly clear that it should not be used as the ‘standard benchmark’.

Using the S&P 500 is like your mechanic telling you how your car is doing but only in terms of a few parts, such as your tires, windshield and turn signals. Another way of looking at it is your doctor assessing your overall health and only diagnosing your skin tone. In each case there is obviously far more to each assessment and so it should be for the way you evaluate your investment portfolio.

If you look at what the leading asset class was for each year going back the last five years it certainly puts things in perspective. Below we highlight the top three asset classes for each year (out of 12 possible).

1 Real Estate 25.30%
2014 2 Large-Cap 13.48%
3 Mid-Cap 9.80%
1 Small-Cap 41.30%
2013 2 Mid-Cap 33.50%
3 Large-Cap 32.40%
1 Emerging Mkt Bonds 22.80%
2012 2 Emerging Mkt Stocks 18.60%
3 International Stocks 17.90%
1 Bonds 8.60%
2011 2 Emerging Mkt Bonds 5.90%
3 Real Estate 4.70%
1 Mid-Cap Stocks 26.60%
2010 2 Small-Cap Stocks 26.30%
3 Real Estate 23.50%
1 Emerging Mkt Stocks 79%
2009 2 High Yield Bonds 57.50%
3 Mid-Cap Stocks 37.40%

If you look at the top three performing sectors going back to 2000, Large-Cap stocks (S&P 500) were in the top three a total of only two times. Large-caps were actually in the bottom half, 10 of the last 15 years (which is 2/3 of the time!) Ironically enough, Real Estate and Emerging Markets out performed most asset classes 50% of the time but the average investor is usually underexposed or void of both.

This leads us to the next question, what should investors do based on these statistics? Should investors simply put an equal weighting in every asset class and accept the fact that they will have positive and negative returns within their portfolio but hope they will average out to a positive return?

The simple answer to these questions is NO.   Rather than attempting to build out an unmanageable mix of asset classes or try to chase returns investors need to have a strategy and proper benchmark assigned to their portfolio. As you build out and assess your portfolio remember these key guidelines:

  • Turn off the media! General market data that only reflects large-cap stocks should not be used unless you only own large-cap stocks!
  • Don’t make long-term investment decisions based on monthly or quarterly performance results. The top performing asset class in the first quarter of the year is rarely the leader at the end of the year. (Conversely, the year is young but take as an example, International stocks right now; they are leading domestic stocks but they were the worst performing equity asset class in 2014)
  • Construct a diversified portfolio using a variety of asset classes and sectors that account for your risk tolerance and goals. Simply looking at large-cap equities does not paint the complete picture.

benchmark3A properly constructed portfolio will participate in rising markets and also offer a level of protection in negative market environments. Lastly, and we’ve said this before…A truly diversified and intelligently designed portfolio will ALWAYS have at least one thing in there that drives you nuts.

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