Measuring Success: Risks Associated With Competing Against A Stock Index

Wealth Managers are constantly confronting the expectation of many investors that the value they provide is strictly measured based on outperforming an index such as the S&P 500. (The S&P 500 is an index composed of 500 of the largest companies listed on the New York Stock Exchange.)

I contend that this is too narrow a measure for successful investing, and that rather than focusing solely on generating higher returns than an index, an investor should take other factors into consideration when designing a portfolio.

When partnering with a financial advisor, the expectation should not be that the advisor has to beat an index to demonstrate that his is a successful investment strategy. Obviously, performance is important. However, too often an investor gets caught up in trying to beat or mirror an index such as the S&P 500. An investor would be better served focusing on what he needs from the portfolio (e.g.: growth/income/capital preservation), and what is suitable for him. He should then customize an investment plan accordingly.

Let us examine how focusing too heavily on competing against an index can distort an investor’s judgment of what constitutes success in the market, thus exposing him to greater risk.

One of the primary roles of a Wealth Manager is to align a portfolio with his client’s risk and return objectives while considering any constraints the client may face. These constraints may include the need for liquidity, exposure to taxes, or a unique constraint. An example of a unique constraint may be a person unwilling to invest in certain industries, such as tobacco.

The advisor then should incorporate assets or strategies the client may be unaware of that the advisor feels can add value to the portfolio. These assets or strategies may be investments that the advisor believes may potentially offer strong returns relative to the risk involved. These investments are incorporated into the portfolio with the intention of making the portfolio more efficient. By doing so, one may seek to reduce risk while targeting the same return, or strive to maintain the same level of risk and target higher returns.

There are other advantages to partnering with a financial advisor. These services include providing the client with a high level of customer service, or guiding the client towards improving his financial picture outside of portfolio management. Perhaps the client needs to update a Will or create a trust, and the advisor can refer him to an attorney who works with the Wealth Manager to coordinate the client’s investment strategy with his estate plan. Although these additional services are important, in many cases they are secondary to the primary services outlined above. (I’ve attached a brochure that outlines primary and secondary services that I offer.)

Notice that beating the S&P 500 or any other index was not mentioned above when summing up a Wealth Manager’s “job description”. Some investors don’t need stock index-like returns to reach their goals. For example, if you are retired and require 4% income from your portfolio and 2% growth to offset inflation, that’s a 6% total return. If an investor allocates 100% to stocks he may be leaving himself open to excess risk with which he may be uncomfortable.

+ Michael Lebowitz, CFA (at 720 Global) recently published an article titled “Bubbles and Elevators”. To support my view on clients overly focused on beating an index, he states the following:

“When managers benchmark their clients’ performance to that stock and /or bond market, they are blindly aiming for a return that does not correspond with their clients’ wealth objective, but to the whims of other investors. A clear wealth building objective would be to outperform inflation by a given margin or, in other words, increase purchasing power.”

What investors must realize is that risk and return go hand in hand. If you want the returns of the S&P 500, you must be willing to take similar risks to pursue those returns, risks that may not be prudent for that particular investor.

People tend to have short memories. They focus on recent returns and forget performance over a longer cycle. Rather than focusing on returns since 2009, let’s view price returns of the S&P 500 since 2000. I will refer to risk as Max Drawdown. This measures return from peak to trough. Then let’s examine how long it took for the index to capture its losses, referred to as Drawdown Duration.

Above you can see that there have been two instances this century where the S&P 500 declined 50% or more, and on average it took about 6 years to recapture those losses. For example, the S&P 500 price in March 2000 was 1552, and didn’t reach that price again until July 2007. (One of the reasons it takes so much longer to recapture losses is because when there’s a 50% loss, you need 100% gain to get back to breaking even).

Many investors who are approaching or in retirement are not comfortable with that type of volatility. It appears that some investors who experienced this volatility in the past liquidated their portfolio as the S&P 500 declined, and never recaptured their losses. During these time periods, an investor who did not focus on mirroring a stock index, but chose to diversify in other assets and strategies, would most likely not have taken such steep losses from peak to trough. This means he might be less likely to sell his holdings when his portfolio was declining, and that the Drawdown Duration period was shorter.

I stress these downturns not to forecast that this will happen any time soon, but to suggest to those investors who have the vast majority of their portfolio invested in stocks with the intention of earning greater returns than an index should also understand the risk involved. It may not be in an investor’s best interest to focus solely on competing with an index. On the opposite side of the spectrum, I also believe allocating a large percentage to cash is a mistake (view my previous article on Dollar Cost Averaging as to why).

If you are an investor who is comfortable with drawdowns of 50+%, then perhaps investing in 100% stocks or trying to mirror an index is appropriate. If not, then please consider diversifying towards other asset classes. These asset classes include Bonds and Alternatives. Just as stocks have subsets of asset classes (small, mid, large, international), Bonds and Alternatives also have subsets. Even diversifying among other investment strategies may be an advantage during bear markets, because these strategies may generate appreciation if stocks decline.

When incorporating Bonds and Alternatives into a long only stock portfolio, investors may be settling for a lower long term return, but they may experience much less volatility. For those approaching or in retirement, that is a more prudent path to follow.

Thank you,

Philip B. Snyder, CFA

+ 720 Global is an investment consulting firm, specializing in macroeconomic research, valuations, strategic asset allocation, and risk management for investment managers. Click here to read full article
*Historical Data derived from Yahoo Finance. 718800&interval=1wk&filter=history&frequency=1wk 9643600&interval=1wk&filter=history&frequency=1wk
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Stock investing involves risk including loss of principal.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.

About the Author:

Philip is a graduate of Hofstra University with a Bachelor of Arts in Business Management. He is a Chartered Financial Analyst Charter Holder and a member of the Baltimore CFA Society. He is FINRA Series 7 and 66 licensed.