How come when the markets seem to gain upward momentum following a period of volatility, some investor portfolios still appear to underperform?
The simple answer for many is that their portfolio isn’t the S&P 500, or any other index such as the Dow Jones Industrial Average. Whereas an investment portfolio is built based on an investor’s objectives and risk tolerance, the S&P 500 is not. As an index, its only objective is to replicate the aggregate performance of the top 500 large-cap stocks in the U.S. It doesn’t care about you or your investment objectives, which is why it shouldn’t be the benchmark investors use to gauge their portfolios’ performance.
The S&P 500 is not a Diversified Portfolio
Investors who follow sound investment principles by diversifying their portfolios might include investments in the S&P 500 index. But they also include investments in small-cap indexes, mid-cap indexes, international stocks, intermediate and long-term bonds, and other asset classes that don’t perform in the same way as the S&P 500.(1)
That’s how investors achieve diversification, which is the recognition that it’s impossible to predict which investments will outperform or underperform other investments at any given time. By diversifying your portfolios, investors minimize your downside risk, but they also limit your upside potential. So, when U.S. equities perform well, bonds may not. Lower returns on bonds may partially offset any gains from equities in your portfolio.
When the S&P 500 Outperforms a Diversified Portfolio
But here’s the thing: When stocks perform well, the S&P 500 is likely to perform well. When stocks perform poorly, so will the S&P 500. A well-diversified investment portfolio may underperform the S&P 500 in a strong market, but it could also potentially outperform the index (in other words, decline less) in a down market—because it’s diversified.
For the following example, let’s assume an advisor has helped you build a diversified portfolio, which is tracked using a variety of indices (see footnote 1 for the full breakdown).
From the second quarter of 2020 (following the pandemic-induced stock market crash) through the end of 2021, the S&P 500 gained an astonishing 119 percent. During the same period, let’s say that a diversified portfolio — which includes small, mid, and large-cap stocks, global stocks, and bonds — only achieved 67 percent returns. Considering the historic bull market of 2009-2020, the S&P 500 gained 351 percent compared to the diversified portfolio’s 219 percent.(2)
You might say that diversified investors are being robbed, which would be true if all you looked at were brief snapshots of the stock market. But over time, a diversified portfolio protects investors from exposing their money to too much risk.
When a Diversified Portfolio Outperforms the S&P 500
Investors looking to build wealth throughout their lifetime don’t typically just invest for one year or even 10. Most invest for the long term—15, 20 to 30 years or more—during which there are also periods of declining stock prices. That’s when a diversified portfolio comes through for investors.
For example, when the S&P 500 declined 30 percent in the first quarter of 2020, the diversified portfolio mentioned above only fell 23 percent. That performance gap gets even more pronounced with more significant stock market declines. The 2000 to 2002 market decline sent the S&P500 down 40%, while the diversified portfolio lost just 15.7%. The index lost 37 percent in the 2008 crash compared to 26.6% for the diversified portfolio.(2)
The Investor’s Bottom Line
The bottom line is that with a portfolio diversified across several asset classes, the highs may not be as high as the S&P 500 index—but the lows are not likely to be as low, meaning the portfolio has less to recover from. And, when the market turns volatile, diversification can cushion the portfolio from the severe downward swings that come with investing.
The critical takeaway is it doesn’t matter how the S&P 500 is performing today, over the next month, or the following year. When you and your financial advisor develop an investment strategy, it’s based on your own long-term objectives, not anticipated market performance. Investor benchmarks based on specific objectives are more meaningful than a market index that has little to do with you reaching your goals.
As long as your portfolio is on track to achieving the required returns to meet your objectives, you don’t need to distract yourself with the daily, monthly, or even annual minutia of the markets. If you’re ever worried about market performance or need help building a properly diversified portfolio, don’t hesitate to reach out to our team today.
Sources:
1 In this case, a diversified portfolio is represented by 25% S&P 500 Index,19% Russell Mid Cap Index, 7% MSCI EAFE Index, 5% Russell 2000 Index, 4% FTSE Emerging Stock Index, 25% Bloomberg U.S. Aggregate Bond Index, and 15% Bloomberg U.S. Corporate High Yield Index.
2 Diversification Can Feel Disappointing