At some point, nearly every investor becomes unhappy with their returns because they are not keeping up with the S&P 500 Index. Well, of course, you might be disappointed when you see the Index’s last 12 months’ return through Sept. 1, 2018 was 19.46%; or the last 24 months’ annualized return through Sept. 1 was 17.95%; or the last 36 months’ annualized return through Sept. 1 is 17.27%.
What you need to keep in mind is that the S&P 500 Index is a market capitalization weighted index, which means larger companies will have a higher weight in the index. As of Sept 1, Apple, Inc., was the largest with a market capitalization of 1.053 trillion. The smallest member of the index was News Corp., with a market capitalization of 7.422 billion. This means when Apple’s share price increases, its market capitalization also rises, and its value in the S&P 500 portfolio also increases, assuming it rises more than the index average. Apple’s fluctuations have a much more meaningful effect on the index than that of News Corp’s.
Because of this market capitalization weighting, the Information Technology sector has grown to more than 26% of the index—a significant concentration by any measure. Furthermore, prices within the Information Technology sector are much more volatile than the overall market; therefore, they move up and down more frequently and at a greater magnitude than the overall index. While you can expect Information Technology to move higher faster when things are good, you need to keep in mind that they can also move down faster too.
As a result, perhaps the S&P 500 Index is not the most appropriate benchmark to compare your own portfolio against. The S&P is certainly good to reflect the overall economy, but the index has much more inherent risk than a carefully crafted, well-diversified, actively managed portfolio. We would all love to earn 20% a year, but an actively managed portfolio provides a protection aspect you don’t see. While an actively managed portfolio may occasionally trail the benchmark, it is likely taking on much less risk as well; therefore, you are not going to be compensated with outsized returns.
We prefer to look at fundamentals, such as the earnings underlying the securities. Often, in the Information Technology sector we see prices that outstrip the growth in earnings. As investors, we want cash flow. We want to invest in companies that will bring us more cash in the future than we paid for it today. When you chase index returns, you’re also participating in buying high and selling low. Remember, when a stock’s price rises, its market capitalization also rises, which in turn, means that its weighting in the index increases, and to keep up with the index, you would need to buy more shares of that stock to reflect the increased weighting. This, then forces you to buy more shares when the price is high.
When we craft a financial plan, we will occasionally see clients who can benefit from taking on the additional risk with their asset allocation; however, those are exceptions, not the norm. If your plan shows that you only need a 5% return to make your money last comfortably through your life expectancy, why expose your life savings to excessive risk unnecessarily? Do you want a 20% return? Yes, of course. But, do you need it? Probably not. To be successful, you only need a growth rate that will allow you to achieve your financial goals.
If you’re solely focused on the returns, is it worth jeopardizing the nest egg you’ve worked your entire life to accumulate over a couple of percentage points? A well-diversified portfolio should still allow you to participate in market rallies and do well with a more conservative approach that protects your purchasing power.
If you have questions regarding your allocation, the experts at Henssler Financial will be glad to help: