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Comparing Portfolio Returns to "the Market"

Comparing Portfolio Returns to "the Market"

| October 19, 2020

Many investors think of the S&P 500, the Dow Jones, or NASDAQ indices when they think of investing. These are widely touted as “The Market” in virtually every news source available. Thus, it seems appropriate to compare your investment portfolio to these indices, right?

First, let's explore the composition of these indices and what they are designed to track:

S&P 500 – Comprised of 500 large U.S. based company’s stock representing a benchmark for the largest corporations by market capitalization. 

Dow Jones Industrial Average – Comprised of 30 large U.S. based company’s stock representing a benchmark for tracking blue-chip stocks in a non-capitalization weighted arrangement.

NASDAQ - Comprised of more than 3,300 stocks, some of which are non-U.S. based, with a heavy weighing (~48%) in the technology sector. This capitalization weighted index is generally used to track technology sector performance. 

Next, we will dive a bit deeper and break down the top 5 holdings in each of these indices and discuss how these indexes arrive at calculating “performance,"

As you can see, the S&P and NASDAQ indices share the same top five holdings. These two indices also utilize a market capitalization weighting valuation method. This is when individual components or securities are weighted according to their size. If we look the S&P for example, although Apple is only one of 500 stocks represented in that index, its effect on the index's performance is many times greater than smaller capitalized stocks within the index. As the largest stocks grow in size, the index (and investments designed to mirror the index) becomes less and less diversified. This could also lead to magnified gains or losses as the momentum of these few stocks picks up.

I’d also like to call your attention to the final column in the visual breakdown above, the section titled “Weight of top 5 stocks”. Staying with the S&P as an example, the top 5 stocks within that index represent 24% of its capitalization! This overweighting is even more prevalent within the other indices. This is not new news, in fact, looking back over the last 40 years we see that there have been variations in the top place holders (AT&T, General Motors, General Electric, Exxon, Marathon Oil, Dupont, IBM, etc.) but the capitalization weighting of the top 10 holdings has stayed within the range of 17.5% - 25.5% putting us slightly above the 40 year average today.

The portfolio strategies we implement contain globally diversified investment allocations. A typical portfolio under our management is comprised of ~4,000 stocks. This provides much more diversification than any one index, diversification that extends beyond the entire US market. The funds within our globally diversified portfolios are not capitalization weighted so as certain stocks grow in size relative to others, they are not over-represented in the portfolio.

Diversification is important for a number of reasons:  

  • It allows us to avoid having too much of a stake during market cycles when U.S. large company stocks under perform other assets classes. For example, over the entire decade ending in 2009, the S&P 500 Index was down over 9%.
  • Diversification also provides us with the ability to produce income from the asset classes within your portfolio that are providing good relative performance. This in turn allows the temporarily undervalued positions to remain invested so that it may eventually recover (buy low, sell high).
  • It reduces overall volatility increasing the likelihood that you will remain invested during volatile market periods. One poorly timed decision could drastically affect your long-term financial security. Maintaining a consistent asset allocation is a key ingredient in the recipe for success. 

Most of our portfolios contain Dimensional Fund Advisor (DFA) holdings. DFA over-weights allocation in areas of the market that have been proven over time to provide better long-term returns than the market in general. These observed premiums are mainly in equities with a specific focus on smaller companies, value stocks (over companies that are focused on growth), and highly profitable businesses. This is a much larger scope than the pure U.S. focused large capitalization companies represented in the indices described above. 

Many folks have scratched their head at the performance of the indices this year. Wondering how, in the face of uncertainly, during a global pandemic, could the S&P continue to rise? The answer is simple. The performance is based on a small number of companies that happened to do very well in this type of environment – Facebook, Apple, Amazon, Netflix, Google (Alphabet) – were all positioned to exceed in world where folks were urged to stay home and hunker down. Online shopping increased, digital streaming subscriptions skyrocketed, everyone took to virtual means of entertainment, exercising, shopping, communicating, etc. You may be surprised to know that only about 1/3 of the stocks within the S&P are showing positive returns year to date while the remaining 2/3 have lost value. Although, as a whole, thanks to the capitalization weighted returns, the S&P is showing positive returns.

That brings us back to the question of comparing our investment portfolios to the performance of the S&P 500. The indices are largely focused on a small basket of stocks, you own many more. The indices are predominantly U.S. based businesses, your portfolio is globally diversified. The indices are 100% stock/equity, while your portfolio has been tailored to suit your individual investment objectives and goals which means we’ve incorporated different types of investments into your overall asset allocation. Your portfolio contains the stocks that make up these indices and so much more!

No one could predict that this was coming. Nor can anyone accurately and consistently predict what lies ahead. Therefore, we believe that focus should be placed on the things we can control which are our asset allocation, the rate at which we save, and the rate at which we spend. Having a plan in place will help us deal with all of the “uncontrollable” variables such as tax law changes, increased inflationary pressures, lower than expected long-term market returns, etc. Continuing to have regular comprehensive review meetings will allow us to monitor your specific situation and tailor our recommendations based on your individual goals and needs. Let us know if you’d like to schedule our next review!