By Kevin Michels, CFP®
Regardless of who you are, benchmarking your portfolio to the S&P 500 is something we all love to do. Whether you’re a novice investor, hedge fund manager, or financial advisor we all find ourselves comparing our portfolio return (or client’s portfolio return) to the S&P 500.
In a lot of cases this just doesn’t make sense and can leave us feeling like we’re missing the boat which can eventually lead to making some pretty costly mistakes. Here are three reasons why you may be underperforming the S&P 500 year-after-year (and why that’s okay):
1. Your Portfolio Is Made up of More Than Just U.S. Large-Cap Stocks
The S&P 500 consists of the 500 biggest publicly traded companies in the United States. Unless your whole portfolio is invested in stocks (primarily U.S. large-cap stocks) then you’re not comparing apples-to-apples. For the most part, any diversified portfolio will underperform the S&P 500 in most years, but the purpose of a diversified portfolio isn't to outperform the S&P 500, but to maximize the return/risk relationship. (For related reading, see: Benchmark Your Returns With Indexes.)
For example, if you go back to 1970 and compare a diversified portfolio made up of 35% large-cap stocks, 20% small-cap stocks, 15% international stocks and 30% bonds, your portfolio would underperform the S&P 500 60% of the time. However, the worst 10-year period for the diversified portfolio was 1999–2008, the portfolio would have averaged 2.6% per year. The worst 10-year period for the S&P 500 was also 1999–2008 when it averaged -1.38% per year. If less volatility and risk is important to you then you must accept that it is likely your overall return will be less than the S&P 500 over the long term.
2. You Are Emotional
The S&P 500 doesn’t have feelings; it doesn’t have emotions or experience fear, jealousy or greed. On the other hand we all do. One of the biggest mistakes in investing is letting our emotions drive our actions. (For related reading, see: The Financial Markets: When Fear and Greed Take Over.)
Fear of a market crash, unstable economy or prediction of a negative event happening in the future can lead you to selling at the wrong time.
Jealousy of a neighbor, relative, or friend who is constantly talking about their great returns can lead you to buy a risky investment or something you really know nothing about.
Greed during a bull market or recent run in the stock market can make you to lose your long-term vision by ditching your investment plan to chase returns. Being emotionless, in general, is not a trait we desire, but when it comes to investing it should be the trait we most seek.
3. Your Portfolio Incurs Fees, the S&P 500 Does Not
The S&P 500 is not subject to trading, transactional or management fees, your return is. If you’re a DIY investor, you still have to pay the commission on the stock you buy, or the expense ratio on the fund you invest in or the transaction fee the brokerage firm charges. If you’ve hired a financial advisor, in addition to the expense ratio on the fund or the transaction fee on the purchase, you will also pay your management and/or financial planning fee.
Conclusion and Recommendation
Benchmark your portfolio’s return to the required rate of return you have established to reach your goals. For example, if you want to save $1,000,000 in 30 years and you save $10,000 per year then you need to earn 7.32% annually to reach your goal. Do what you need to do to earn that rate of return and don’t look left or right.
Unless your main objective is to specifically outperform the S&P 500, don’t compare your returns to the S&P 500. It will lead to bad decision-making and lower your returns in the long run.
(For more from this author, see: Target Date Funds: Understanding the Benefit and Risks.)
This article was originally published on Investopedia.