Why Diversified Portfolios are Outperforming the S&P 500 Index

Many people regard the S&P 500 Index as a good measure of how their portfolio is doing. However, an investor with a well balanced and diversified investment portfolio should have outperformed this index over the last five years. That is because the S&P 500 represents just one asset type, “large cap” U.S. stocks, and these stocks have done poorly over the last five years.

The accompanying graph of “5-Yr Annualized Total Returns” shows that U.S. large cap stocks have underperformed all other asset classes during the five years ending 1/12/06. A wise investor who built his or her portfolio with many types of investments would have easily beaten the S&P 500 in recent years.Investment Chart

So why does the S&P 500 get so much attention? It clearly is the most widely-watched index of the largest U.S. stocks, and is considered to be a bellwether for the U.S. economy. The stocks represented in this index account for over 75% of the value of all stocks in the United States and are selected to include all major businesses. Thus it really is a good proxy for both the general direction of the U.S. stock market and our nation’s economy.

Due to these characteristics some investors assume the S&P 500 index is a good benchmark for stocks in general. Some investors have gone so far as to dedicate a large portion of their portfolios to S&P 500 index funds (mutual funds that mimic the S&P 500 Index) as a cheap way to buy what they thought was a diversified holding of stocks. Unfortunately, the results over the last five years have left these people sorely disappointed.

There are additional factors as to why the S&P 500 may be an even worse yardstick than we think. First, only 400 of the 500 largest companies are actually in the S&P 500 index. The stocks in it are selected by a committee to represent all major business sectors in our country’s economy and that selection process can affect the outcome of its performance. Second, the S&P is designed so that the largest companies count the most. The ten largest companies in the index, which include names such as Microsoft, Exxon, and General Electric, account for 19% of the total index value. This means that an index fund that seeks to copy the performance of the S&P does not even give you a well-diversified position in large cap stocks.

The wise investor knows that his or her portfolio needs to have additional types of securities. Low interest rates and the real estate boom made Real Estate Investment Trusts (REITs) exceptional performers. Foreign stocks, including both developed markets and emerging markets, went up as the world economy grew. Stocks of small and medium sized U.S. companies did very well as investors recognized the great growth potential of these aggressive companies. Even bonds did well over the past five years until rising interest rates put a damper on them recently.

The recent poor performance of large U.S. stocks is not a reason to exclude this asset class from your portfolio. Large cap stocks have done well in the past. They were the best performers for the years 1995 through 1998. In recent years their profits have been rising handsomely, so they may be good bargains at this time. But trying to bet which asset type will perform best next year (market timing) is fraught with danger, because the market is unpredictable.

Anytime you put a lot of your investments in one asset type, you increase the chance that you will underachieve the overall market. Only by holding all types of investments can you be certain to hold the best performers year after year and earn the most consistent rate of return.

Our recommendation is to keep the S&P 500 in perspective as you listen to the daily update in the news. It is a good indicator for our nation’s economy and the general direction of stocks. But you should not use this index as a benchmark for how your investments are doing or how you should be invested.