Most people are using the S&P 500 index to measure their success. Is this the right strategy for you? If so, watch our video about this topic.
First, let us talk about what investments are in the S&P 500 index. It is a market capitalization-weighted index of the 500 largest publicly traded stocks in the United States and is widely regarded as the best gauge of large-cap US equities. Because this index is used as a measurement of success it makes sense to look under the hood and analyze the performance, what is comprised in the index, and whether it is the best benchmark for your personal goals.
For most investors who want to build and preserve wealth and provide an income stream for the rest of your life, this index poses three big problems. First, this index lacks real diversification. It also does not include opportunities for growth in foreign countries because it is only in the United States. The S&P 500 also does not contain mid and small-sized companies that are generally growing faster than the large companies in the S&P 500. The nimble smaller firms are more dynamic and have new products and new services that are in high demand. Many products even will reshape the way the economy will work in the future. So if you invest in the S&P 500 types companies, you can miss out on a lot of innovation that builds a bigger better tomorrow.
Let’s dive into the S&P 500 and why it lacks diversification. Even though this index has 500 companies in it, investors do not gain diversification benefits during times of stress. Here is an example to show how this works. This chart illustrates the performance of a 60/40 strategic benchmark. This is our benchmark for portfolios that have roughly 60% in stock and 40% in bond. Although we are active managers, we track the passive indexes blended to see the performance that is possible with a broadly diversified portfolio in many different asset classes. The blue line on this chart is the performance of a 60/40 portfolio and it is compared to 100% of your money put in the S&P 500. We started this graph in March of 2000 and the performance ends on April 30, 2020. The data was provided calculated in the Y-Charts engine using Morningstar benchmark data.
As you could see, a $10,000 investment grew to $23 thousand dollars in the balanced portfolio and only $19,000 in the S&P 500 during this time. This really shows you how during volatile periods in stocks, a blended portfolio can do better than an all-stock portfolio in the U.S. The gray vertical lines show when we recession occurred and as expected, the S&P 500 and the blended benchmark both declined in value; but, notice how the S&P 500 had much bigger declines. Is this the kind of performance you can take in your portfolio?
This next chart shows a zigzag indicator that is set to 10%. Every time the market moves down by 10%, the zig-zag indicator will change directions. As you could see many 10% declines occurred and some very large 50% and more have hurt investors. In fact, data tracking the money moving out of mutual funds and ETFs increase dramatically when markets sell-off like this. Investors tend to do pull their money out of investments at the wrong time in many cases and they get hurt because they miss the risk and sold too late.
One of the things that I have noticed is that every time you have one of these big bull markets moving higher, everybody starts talking about indexes. This usually happens past the midpoint of the bull market cycle. There is a tendency to pile into funds that track the indexes like the S&P 500 at this time. But guess what happens when the economy stumbles and the markets get rocky? You guessed it, many people abandon their plans to be an indexer or they cut back, and they have subpar performance. So, is the S&P 500 index the right benchmark for you as an investor? I would argue that it is not the right benchmark for most people if they want to track performance that is doable and appropriate for their goals.
To further illustrate this, let us take a look at the concept of sequence of returns. I will show three different scenarios that were put together by Mackenzie Investments. All three scenarios earn a 5% return and have the same ending value if accumulated with no withdrawals. The only difference is the order of the returns. The first scenario has positive returns in the early years, the second one has negative returns in the early years, and the last one earns 5% every year. If you put a million dollars in over five years in all three scenarios, it would compound out to be $1.274 million in all scenarios. So, if you were accumulating money without withdrawals they are identical. But what happens when you actually start needing your money for retirement? That is when you have a big problem because of reverse compounding. Investors wind up having to sell more shares of their investments when the portfolio is down, and then the portfolio has a harder time recovering later. As you extend this longer past 5 years, it gets more and more pronounced. Let us take a real-life example. This chart shows two scenarios where investors invest a million dollars one invests in January 1998 and another investor buys in August of 1998. If you had been accumulating at that time without withdrawals the difference in their ending wealth is very similar. There is only a slight difference in their values. But when withdrawals are assumed during that same time period, you have a huge difference. With an annual income withdrawn from the portfolio $60,000, one investor has $385,000 leftover, whereas the other investor is depleted in 14 years. This is a real-world example of what can happen. So, what is the solution? Here are some ideas. The first thing to do is to have a part of your portfolio earmarked as a buffer. A buffer is a part of your portfolio, typically worth between 1 and 3 years of your spending needs. These funds are invested in short term high quality fixed income instruments with a shorter-term duration. You can use these funds to meet your spending needs instead of pulling from your longer-term total return portfolio when the markets are down. This will insulate you from some of the sequences of return problem. The second solution us a specific strategy I call “diversified active management”. This approach utilizes two main concepts - asymmetric risk management, and non-correlated assets. Asymmetric risk management is managed at the individual security level so that every position that you invest in has pre-defined risk. A risk budget risk is used to determine how much money to invest in each opportunity and managed along the way for every holding. The manager also must have the discipline to let winners and profits run. So when a certain investment is doing well, the manager has a discipline to stay in the winners to earn bigger potential profits. This helps the manager pursue a return profile were the average winning trade is much larger than the average loser – this an asymmetric return profile. In a statistical sense, that means your returns are skewed to the right. The second component of a “diversified active management” strategy is to blend non-correlated assets. As in the blended benchmark of 60% stock and 40% bond, if you invest in non-correlated assets, it is possible to have a better outcome with lower risk. Of course, past performance is not indicative of future results. When looking for assets to include in your portfolio it is important to analyze two factors - statistical correlation and return drivers of each investment. The idea is to keep the correlation low in both departments. Another solution is creating a floor on your returns. This can be really important for some investors, especially if you are shifting from accumulating wealth into spending an income stream. Because you have a sequence of returns risk, it is really important to consider investing a portion into guaranteed return instruments like a fixed annuity. The research is clear. Using guaranteed fixed annuities can extend the probability of success if you live longer and it gives you a floor level of return each and every year. Another part of the solution is to manage taxes. Managing capital gains to minimize short term gains that are taxed at a higher rate. Also investing in tax-free fixed-income bonds. You want to really watch the order of your withdrawals each type of account that is taxed differently. Generally, it's better to use after-tax money first, then tax-deferred and lastly tax-free money. This can extend the life of your portfolio well beyond taking an income stream from an S&P 500 fund.