When asked how “the market” is doing, the question invariably refers to the performance of the S&P 500 index. Since its inception in 1957, it has become the de facto barometer for the overall health of global financial markets.
The S&P 500 is also popular with individual investors. Beating it makes us feel smart and affords us bragging rights at holiday dinners and rounds of golf. However, there are three reasons why the S&P 500 is an inappropriate benchmark for most investors’ goals.
First, the index is concentrated. It only tracks 503 large-cap stocks weighted by size. The top 10 largest constituents comprise more than 31% of the index1.
Second, the S&P 500 is far too aggressive for most investors. Only those with a strong stomach and a time horizon of at least a decade should hold an all-equity portfolio.
Third, consider an investor with a portfolio of 30% large-cap stocks and 70% bonds. The S&P 500 would be an inadequate benchmark because the heavy bond allocation could skew the risk and return comparisons. Furthermore, any portfolio designed to generate income should not benchmark against an index that yields 1.45% annually and consists of several non-dividend-paying stocks.
Think about it this way. If the S&P 500 was down 38% (as in 2008), and a money manager benchmarked against the S&P 500 was only down 32%, they would be lauded as a genius. Pension funds and endowments would likely beg that manager to take their money.
But would you be happy? Would this make life better? Do your housing, healthcare, and other living expenses rise and fall with the S&P 500 each year? Or would you sit on your couch, head in your hands, sick to your stomach after watching a third of the value of your portfolio disappear?
What’s inside?
The sausage principle states that if you love something, never find out how it is made. Anyone with an affinity towards the S&P 500 may want to skip this section because it’s time to go under the hood.
Most major indices use objective measures such as company size, profitability, and how long they’ve been in business. They are quantitative and carry no subjectivity. The S&P 500 uses a set of rules based on these to govern qualification to the index. But inclusion is a qualitative decision, and those overseeing it have significant influence.
The index is managed by a group of 10 committee members who work for S&P Global. They meet monthly to discuss potential revisions and make changes quarterly. A simple majority decides votes by the index committee, and each member’s vote counts equally. While the name of the Chairman is public, the other members’ identities are kept secret2.
S&P Global does not manage this index as an act of public service. This is a for-profit firm that charges handsomely to license the S&P 500, and it generates serious profits. According to its financial filings, S&P Global earned over $1.35 billion in 2022 from the S&P 500 and other indices it manages3.
Since this is such big business, there is an incentive to treat the S&P 500 as more of a marketing tool than a rules-based index. The more exciting it appears to investors and the media, the higher the likelihood of more licensing fees paid by mutual funds and other financial instruments.
This may be why the number of stocks that go in and out appears high relative to other indices. More than half of the companies in today’s S&P 500 index were not in the index 20 years ago4. During the tech boom of the 1990s, the index was skewed to the tech sector. During the mortgage boom of the 2000s, it was skewed to financials. Neither ended well.
Big investors can also influence the index by placing bets on which stocks might get included over time - raising the price of these stocks. Once a stock gets in, funds that track the index must buy that stock, and this coordinated activity only pushes the price higher. This can result in a lot of expensive stocks being added to the index.
Simply put, the S&P 500 represents a committee of ten people picking stocks for a product that generates around a billion dollars in licensing fees annually. Does this sound like something you want to benchmark your financial future against?
Come prepared
Any serious golfer shows up with a full bag of clubs that each serve a unique purpose - the putter for the greens, the driver to get off the tee, the wedge to throw into the lake after the third attempt to get out of the sand fails, etc.
The same applies to investing. Here, the driver is the stock market. It hits the ball the farthest and creates the most excitement. But seasoned golfers also know what can happen if a drive is off by even a millimeter. The slightest mistake can send the ball toward the moon, and it could take several strokes to get back on track. Hence, it should be used sparingly.
It also takes more than one investment to achieve long-term goals. We need investments to help us grow our nest eggs, but we also need others to guide us through the sand traps in financial markets.
Managing expectations is equally important. No golfer would expect a wedge to outdrive a wood because it’s not designed for distance. Assessing performance involves comparing a wedge shot to other wedge shots, and a drive to other drives. Similarly, comparing a diversified portfolio of bonds, gold, and other asset classes to an index of 500 U.S. stocks will create unrealistic expectations and risk suboptimal investment decisions.
The bottom line
To be clear, there is nothing inherently wrong with the S&P 500. It has its flaws, but so does every other index. But the only investor who should be using the S&P 500 as a benchmark is a money manager paid to beat the S&P 500. Nearly every other investor on the planet should use something else.
For example, a retiree living off investment income should avoid gauging performance against an index that can fall by double-digits in a matter of weeks. A more appropriate benchmark would be inflation or some cost-of-living measurement.
Herein lies the challenge. Everyone is different. Some aim to preserve what they’ve earned, while others want to grow it. Some can ignore the volatility in stocks, and others lose sleep over it. This is why proper risk assessment and managing expectations are so important. That way, the emotional impact can more closely track the financial one.
The bottom line is that “the market” is one of many markets, and therefore, it is not a benchmark for diversified portfolios. Ignore the adrenaline rush that comes with a big drive down the fairway because a good score also requires a strong short game.
Sources
1 Bloomberg. As of 6/30/2023
2 https://qz.com/1587963/how-the-sp-500-is-built-and-who-decides-what-companies-go-in-it/
3 S&P Global 2022 Annual Report
4 https://www.exchangecapital.com/blog/why-the-sp-500-isnt-what-you-think-it-is
Disclosures
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.