Why the S&P 500 may fail as your portfolio’s benchmark

The goal of the equity index has little in common with the goal of a diversified, retirement portfolio.

Article published: May 15, 2023

How many times have you used the S&P 500’s returns to gauge the performance of your retirement portfolio? If your retirement portfolio is diversified across bonds and stocks as well as across geographies – which it should be – then comparing your portfolio’s performance to this U.S. stock market index makes little sense. Yet, many of us do exactly that.

“Would you measure your health by just taking your blood pressure? Probably not,” says wealth planner Ron Sisk. “Your portfolio should be built with your specific goals in mind. Comparing your mix of investments to the S&P 500 is not fair to you.”

The bigger problem occurs when you want your retirement portfolio to look more like the S&P 500 in any given period in order to chase the index’s performance. Yes, indeed, the risks of using the S&P 500 as a benchmark for your portfolio are worth knowing about in greater detail. Let’s explore.

What the S&P 500 is and what it isn’t

We should first make clear that we do not question the utility of the S&P 500 as a U.S. stock market barometer.

The stock market’s “value” can be measured by aggregating stock market capitalizations, i.e., the price of a stock multiplied by its number of shares outstanding. Because the index is market-cap weighted, the S&P 500’s value is driven by the performance of the stocks with the largest market capitalizations, which is a substantial percentage of the overall U.S. equity market value.

However, the index only includes 500 stocks, and only large-cap stocks at that. Compare that to the U.S. equity market, which consists of more than 6,000 stocks, not to mention there are thousands more across the globe. These facts only underscore why the S&P 500 is a flawed benchmark for a diversified retirement portfolio.

Sure, the S&P 500’s returns are seductive on the surface

The S&P 500 has posted impressive returns over both short- and long-term periods. Some may be tempted to change their portfolio’s exposures so they’re similar to the index’s or to invest all their retirement money in a fund that tracks this index.

We believe U.S. large-cap stocks should be in most retirement portfolios, but they are only a fraction of the world’s overall investable assets.

 

“Ignoring all of the other assets means you don’t get the diversification benefits of Treasury bonds, corporate bonds, mortgage bonds and real estate,” says Vice President of Financial Research Wei Hu. “When you include these other asset classes, your overall performance may not have the highest highs, but it also may not have the lowest lows, which is what you want for a retirement portfolio,” says Hu.

Moreover, the biggest pension funds and endowment funds don’t limit themselves to just investing in U.S. large-cap stocks – why should you?

The broader point is that the S&P 500’s primary function is not that of an investment but to be a U.S. stock market index – a mandate that your retirement portfolio does not share.

Invest for your goals – not an index’s

The goal of your retirement portfolio is to grow and protect your wealth at your own risk level and with a financial horizon that may be 30 years or more.

Given its differences from the S&P 500, your retirement portfolio may still be on track with its long-term goals when the S&P 500 has a year or two of negative returns. Your portfolio’s performance is measured in decades and will likely include a number of economic and market cycles.

To potentially benefit from changing market cycles here and abroad while seeking to mitigate risk, we believe diversification is necessary. Many Edelman Financial Engines portfolios, for example, are allocated across geographies and 16 asset classes. They likely have exposure to stocks in the S&P 500 but also to those in international stock indexes as well as bonds and more.

Next time you compare your portfolio to the S&P 500, remember that the index may have little to do with the financial goals you are working hard to achieve.

The power of diversification

Although past performance doesn’t guarantee future results, a diversified portfolio has the potential to benefit from rallies in different asset classes, which are difficult to predict.

Performance of different asset classes year to date, 1 year and 3 year mark are shown. Performance greatly varies over time and across classes.

 

Source: Morningstar Direct.

Note: Three-year returns are annualized. Asset class performance is presented by using total returns from an index proxy that best represents its respective broad asset class: Cash (USTREAS T-Bill Cnst Mat Rate 1 Yr), Corp. Bonds (BBgBarc US Corp Bond TR USD), Emg. Markets (MSCI EM NR USD), European Stocks (MSCI Europe NR USD), Int. Treasuries (BBgBarc US Govt Interm TR USD), Large Growth (S&P 500 Growth TR USD), Large Value (S&P 500 Value TR USD), Long Treasuries (BBgBarc US Government Long TR USD), Mid Growth (S&P Mid-Cap 400 Growth TR USD), Mid Value (S&P Mid-Cap 400 Value TR USD), Mortgage Bonds (BBgBarc US MBS TR USD), Non-U.S. Bonds (FTSE WGBI NonUSD USD), Pacific Stocks (MSCI Pacific NR USD), Real Estate (FTSE NAREIT All Equity REIT TR), Small Growth (S&P Small-Cap 600 Growth TR USD) and Small Value (S&P Small-Cap 600 Value TR USD).


Investing strategies, such as asset allocation, diversification or rebalancing, do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. All investments have inherent risks, including loss of principal. There are no guarantees that a portfolio employing these or any other strategy will outperform a portfolio that does not engage in such strategies. Past performance does not guarantee future results.

 

An index is a portfolio of specific securities (such as the S&P 500, Dow Jones Industrial Average and Nasdaq composite), the performance of which is often used as a benchmark in judging the relative performance of certain asset classes. Indexes are unmanaged portfolios and investors cannot invest directly in an index. Past performance does not guarantee future results.

 



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