Question: The S&P 500 stock market index, which is reported daily and prominently on financial websites, TV and radio, and in the newspaper, was up 13.7% in 2014. I use a financial advisor and my portfolio during the same time period was only up 4%. There is a big difference between 4% and 13.7%. Should I fire my advisor?
Answer: Probably not. In fact, if your portfolio had been up as much as the S&P 500, 13.7% last year, you might have a better reason to fire your advisor.
The S&P 500, or the Standard & Poor's 500, is an American stock market index consisting of 500 large U.S. companies. It is weighted by market capitalization and its index components and their weightings are determined by S&P Dow Jones Indices. The top 10 constituents of the index are Apple Inc., Exxon Mobil Corp, Microsoft Corp, Johnson & Johnson, Berkshire Hathaway B, Wells Fargo & Co, General Electric Co, Proctor & Gamble, JP Morgan Chase & Co, and Pfizer Inc. These 10 companies represent over 17% of the index by weight.
The reason you need to be concerned if your portfolio was up as much as the S&P 500 last year is because you are probably heavily exposed to risk and not adequately diversified. Individual markets can be volatile, and the S&P 500 is no exception. For example, if you had $100,000 invested in an S&P 500 index fund on October 9, 2007 that fund would have lost over half of its value in the next 17 months. Your $100,000 would have dropped in value to $43,000 and, if you had the willpower to stay fully invested at the bottom, it would have taken you four years to recover.
You can avoid that kind of volatility and get a reasonable rate of return if you diversify your portfolio using various asset classes. You know you need to take some risk to get a return greater than the risk-free return of a CD or U.S. Treasury Bill. Diversification doesn’t eliminate risk, but it does remove risks you don’t need to take.
For example, a company might do poorly. Its stock price might crash, and its shareholders will suffer. By investing in an S&P 500 index fund, you diversify away individual company risk because you own a share of 500 companies. The S&P 500 index represents the large U.S. stock asset class. Other asset classes include U.S. small company stocks, international stocks, emerging market stocks, bonds, and cash. Some investors will add other asset classes, such as REITs (Real Estate Investment Trusts) and Commodities. By diversifying into different countries around the world, you diversify away some country risk. If you are invested in U.S., European, and Asian stocks and one of those countries has a very bad year, you won’t be hurt as badly.
In 2014, well-diversified portfolios had returns between 3% and 5%. Morningstar, a leading provider of independent investment research, tracks five target risk portfolios ranging from aggressive (95% global stocks) to conservative (20% global stocks). Their most aggressive portfolio returned 5.23% and the most conservative portfolio returned 3.38% last year. If you were to invest in these indexes using mutual funds or exchange-traded funds, your returns would have been even lower because of investment fees and expenses.
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to email@example.com.