It’s Been a Lost Decade for Most Equity Investors, But it Didn’t Have to Be

Back about 10 years ago, I spent a lot of time trying to explain to folks why just buying the S&P 500 index was a bad idea. I remember vividly how some of our clients and prospects at the time felt that we were just making excuses for not keeping our performance up to S&P, which was soaring. Our explanation was simple: we were not going to buy investments that were clearly overvalued. But I could tell that our explanation seemed like a lame excuse for poor performance. Now, after more than 10 years, we can conclusively demonstrate that our reasoning was right. Here is an explanation and the facts.

One of the problems with trying to match the S&P 500’s returns is that the index is market-cap weighted. This means that larger companies influence the movement of the index more than smaller companies in the index. A $1 change in the price of Exxon (the largest stock in the S&P 500 and currently selling for about $80/share) causes the index to move twice as much as a $1 change in the price of a company also selling at $80/share but half as big as Exxon. This means that if your investments are “benchmarked” to the S&P 500, your investment results (i.e., performance) will mirror the results of the index. The problem is, it simply does not make sense to buy twice as much of a stock just because it’s twice as big as another stock. Bigger companies simply do not outperform smaller companies just because they are bigger; the evidence is to the contrary.

Here are the facts. The S&P 500 index is still down about 19% from its dot-com high in March of 2000. But if you ignored size and owned an equal dollar amount of each stock in the index, your portfolio would be up about 66% from March 24, 2000 through December 2, 2011.

The difference in performance is remarkable. And, according to S&P, most equity investors ($5.8 trillion) are still benchmarked to the S&P 500 index, mostly through mutual funds. Owners of stocks in the largest companies, represented by the S&P 100 index, suffered the most; this index fell 33%, driven by declines in the largest companies at the time, Cisco Systems, General Electric and Microsoft.

These past 10 years have seen the 9/11 attacks, the dot-com bubble, the collapse of real estate values, the worst financial crisis in the U.S. since the Great Depression, multiple wars, a tsunami in Japan, and serious problems throughout Europe. Yet, if you invested intelligently in stocks over that time, you did fine. It’s unfortunate that most investors didn’t.