I venture to say every investor wants to have a good return on their portfolio. But what is a good return, and how do you know? As a financial advisor, this is one of the most challenging things for us to explain to a client in terms that are easy to understand and “feel” right to those we serve. Portfolio construction is complex and is about as easy to comprehend to someone outside our industry as someone explaining how DNA sequencing works to someone like me. I can say that with confidence because I have several clients that are involved in DNA sequencing and I find myself ignorantly nodding my head when they give me the “easy” explanation of how it works hoping perhaps they won’t realize I’m completely lost (which I’m sure they know), and maybe more importantly because it seems like the polite thing to do until their satisfied that I should understand it! The universe of benchmarking the performance of an investment portfolio is vast and far too much to address in this one blog, especially if I have any chance of keeping your attention beyond this paragraph. Today we are going to explore the long-held belief that the S&P 500 is a good benchmark for your portfolio because it’s a broad measure of the U.S. economy.
What is the S&P 500?
The S&P500 by definition is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. Many times, it’s more simply referred to as the 500 largest publicly traded companies in the U.S and anecdotally believed to be a broad measure of the U.S. economy. Technically, there are 503 securities in the index because three companies have two separate share classes.
Let’s define “market-capitalization-weighted” just to make sure everyone is on the same page. Market capitalization simply means the theoretical value of a company if you added up all of its stock together based on the current price per share. Market-capitalization-weighted then means that the companies with the largest market capitalization have a disproportional weighting in the index relative to their peers. Said more simply, bigger companies have a larger impact on the performance of the S&P 500 index.
Why is the S&P 500 important?
There are roughly 3,500 publicly traded companies in the United States and while the S&P 500 only makes up a small share of those, it contributes roughly 80% of the total market capitalization of all publicly traded companies.2 From that, one could certainly infer that the S&P 500 is in fact a good measure of the U.S. economy. Additionally, many of the companies listed in the S&P 500 are global brands. Think of Apple, Facebook and Google. Just about anywhere on the planet you’ll be able to find people that know who these companies are and what they do. S&P 500 companies by their very nature happen to be the largest proportion of most investors U.S. equity exposure because these companies, due to their size, tend to be more stable and therefore “safer” investments that investors can count on. Now this doesn’t always prove to be true, but in general companies like Apple, Facebook and Google are more likely to be able to withstand challenging economic speedbumps due to their cash flow, size and diversification of products / clients. Lastly, tracking the S&P 500 is simple. It’s on every financial app, tv show and newspaper you might pick up. For all the reasons above, talking heads have touted the S&P 500 as THE benchmark by which you should judge your portfolio. But is that a good idea…
Is the S&P 500 a good benchmark for your portfolio?
Spoiler alert – the answer is going to be no…mostly. A benchmark is meant to be a tool from which you can measure relative value or performance. The most important thing you can do when choosing a benchmark is to choose one that has a similar investment allocation to the way you are invested. To give a simple example, if you wanted to know how good of an apple you have, you would need to compare it to another apple, or set of apples. That seems self-evident. You wouldn’t compare your apple to an orange because it’s not the same thing. That said, if you didn’t know a lot about apples, an orange does pass several general benchmarking tests. It’s a fruit, it’s round and it’s approximately similar in size. Yet you’d never compare the two, right? After all, that’s why we use the phrase, “…it’s apples and oranges.”
So, let’s peel back some layers of the S&P 500 to see what it really is. Returning to the concept of market capitalization and the relative weighting of the S&P 500; what do you suppose the weighting is of the top 10 companies in the index? The answer is 36%. To give you a relative comparison, you’d have to add up the bottom 473 companies in the same index to get nearly the same weighting. So, the top 10 companies impact the performance of the S&P 500 just as much as the bottom 473…Yikes!
Next, let’s look at performance as of 11/30/24 YTD. The S&P 500 index was up approximately 28%. Of that, how much do you think was attributed to the top 10 stocks in the index? The answer is about 21%. So that is to say that the bottom 490 companies produced only 7% of your total return in the S&P 500. If we weighted all the stocks equally in the whole index, our YTD performance would be 20%. Furthermore, do you think you could name the best and worst performers YTD? The best performer is Vistra Corp (VST :+318%) which is a power generation company in Texas. Unfortunately, they are only weighted at 0.09% of the S&P 500. The worst performer is Walgreens Boots Alliance Inc. (WBA: -63%) which mostly owns Walgreens and Boots franchises in the U.S. and U.K. Fortunately, they only make up 0.01% of the index. The bottom line here is that the majority of the companies in the index, regardless of their performance, have very little impact on the overall return.
Lastly, let’s divide the index up by sector. Sorting this way we find the Information Technology (Tech, as normal people call it) makes up 14% of the companies, but accounts for a whopping 32% of the weighting. If you include Communications Services (Meta, Google and Netflix, sooooo… more tech) that bumps you up to 18% of the total companies and a contribution of 41% to the overall weight of the index. Now let’s look at the bottom six sectors by weighting: Materials, Real Estate, Utilities, Energy, Consumer Staples and Industrials. These sectors combined account for 46% of the companies in the index, but only 25% of the weighting.
As you can see, no matter how you dissect the S&P 500 it’s a very top-heavy, sector specific measuring stick and unfortunately, that’s not a very useful tool for the average investor whose portfolio is diversified. It’s apples and oranges.
But, wait a minute, why wouldn’t you want your portfolio to be lopsided if that’s where the bulk of the returns are coming from?!?!?!? Great question, Jason. Thank you for asking! We believe very investor’s portfolio should be set up to help them achieve the goals for which the investment proceeds will be used. For our clients that is generally some measure of retirement income, paying for college, traveling, a second home, etc. Their goals are philosophically centered around the security of their needs and those things that will give them a meaningful and fulfilling life. Afterall, if not for the opportunity to enjoy a fulfilling and meaningful life, why exchange all the hours, days, weeks, months and years you have in order to build up your nest egg?
So, we have to ask ourselves what’s more important; The possibility of greater returns or having a greater chance of having the money needed to achieve our financial goals? It’s generally not complicated when you sit down and really consider it.
What’s a better option?
When talking with clients I find that more times than not when a client compares their portfolio to the S&P 500 what they’re actually saying one of two things, either; I’m tired of my job and I’d like to stop, and/or; how can I know we’re getting a reasonable return on our investments?
Benchmarking is a really difficult thing to do well, even as a professional in the industry I find it challenging. For decades the S&P 500 was a reasonable benchmark for U.S. equities because the sectors were more evenly weighted and so were the individual stocks. The growth in tech over the last 10 years has changed everything. I have tools that allow me to get a little more granular than the average person which gives me a leg up in that respect. But, for the average investor, I think the easiest way to approximate a benchmark would be to use a generic allocation ETF that represents the way you are invested. For example, the iShares Core Growth Allocation ETF (AOR) which represent a classic growth approach. It may not be the perfect benchmark, but you’ll have a very basic apples to apples comparison and be less skewed by the glitz of the S&P 500 index. In fact, YTD 11/30/24, AOR was up 13%, which is much lower than the S&P 500 due to it’s diversification. For the most constructive approach, talk with your financial advisor to make sure you are both on the same page regarding how to measure portfolio success. If you are both aligned with what you are shooting for, there is a good chance you’ll be satisfied with the outcome.
Do the right thing
We believe wealth is won and lost in concentration. The major risk you unavoidably assume if you chase the S&P 500 is concentrated exposure. A handful of companies are dictating the outcomes, and they mostly happen to be tech companies. For the sake of the markets, as a business owner and financial advisor, I hope nothing ever happens to these companies! As a pragmatist and fiduciary for my clients, I must consider however that no one saw Enron or WorldCom coming. No one saw the tech wreck in the late 90’s or the financial crisis in 2008 coming.
What’s more important, chasing returns or staying focused on the goals that give you and your family a meaningful and fulling life?
Healthy Plan, Wealthy LifeTM
1 Will Kenton, “S&P 500 Index: What’s it for and Why It’s Important in Investing,” Investopedia, June 12th 2024 https://www.investopedia.com/terms/s/sp500.asp
2 Bank of America, “Surprising Resilience of the S&P 500,” https://www.privatebank.bankofamerica.com/articles/investing-in-sp-500-companies.html?utm_source=chatgpt.com
