When Less is More: The Risk in Comparing Standard Returns to Those of the S&P 500
There was a bit of curiosity at the end of 2014. The S&P500 Index achieved an academic 13.7% return. Investors with a properly diversified portfolio experienced returns of less than 5% Net of Expenses. So, what is the difference between the S&P500 and a properly diversified portfolio?
An important point to make is that the S&P500 is an index, and has no expenses associated with its performance. If we were to associate expenses to the gains, the S&P500 would return about 12%, a difference of about 7% when compared to many diversified portfolios. The index is made up of the 500 largest US Stocks,. According to MSN, The top 10 performing stocks in the S&P500 during 2014 were:
1.Southwest Airlines110% gain
2. Edwards Life Sciences 92%
3. Allergan 86%
4. Avago Technologies 87%
5. Keurig Green Mountain 82%
6. Delta Airlines 66%
7. Royal Carribean 64%
8. Marriott 57%
9. Under Armour 57%
10. Electronic Arts 56%
A large percentage of the profit of the index is due to the impressive returns of a small number of stocks. Investment in any of the stocks listed above would have produced outstanding results. These 10 stocks make up only 2% of the total S&P500 index. Chasing stocks on a whim and hoping to strike lightening in a bottle leads to an unbalanced portfolio and unnecessary exposure to risk. It is important to remember a good diversified portfolio is set up to meet long-term goals.
And who would have thought that long-dated US Treasuries would have had a gain over 27%. Other components of well-diversified portfolios had the following Index returns (without expenses):
1. International Developed (MSCI EAFE) Index -4.9%
2. International Emerging (MSCI EMG'G) Index -2.2%
3. Russell 2000 (Small Cap Stocks) +4.9%
4. High Yield +2.45%
5. Aggregate Bonds +5.97%
Research firm Morningstar constructed several model portfolios with the best returns totaling only 5.23%. Typically, a portfolio might have no more than 20% exposure to the large cap S&P500 type stocks, so it would be unlikely to overcome some of the Negative and Low returns shown above.
Chasing returns will take us to the edge of a bubble type situation similar to the Tech Bubble or the 2008 Real Estate Bubble. As a reminder of how volatile the S&P500 index is, the January (month) 2015 return was a negative .
Over time, proper diversification will bring market returns. It is not advisable to concentrate your investment into one position. Placing all your eggs in one basket creates a tremendous amount of risk. When the bubble bursts on that single position, the investor stands to lose all they had gained.
In a properly diversified portfolio, it would have been virtually impossible to perform as well as the S&P500 did for this year. A portfolio that meets your tolerance for risk and volatility and is constructed to achieve your long-term goals is a better option than risking your wealth hoping to pick high performing stocks.