Many people watch the news every night and look at how the Dow and the S&P 500 ended that day. They see it up or down and think their portfolio should be the same. Simply put, in most cases that is not the case and, in my opinion, should not be the case.
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The Dow Jones Industrial Average that we see on TV represents 30 companies. That's it -- 30. There are thousands of companies out there, yet the Dow represents 30 of those. I have often asked the following question to clients: How many companies are in the Dow 30? People give me many answers, and most do not say 30. The same is for the S&P 500 index, which is also seen on TV daily. It represents 500 large-cap companies, yet there are more than 500 large-cap companies. Many people are not aware that large-cap companies are only one asset class.
Think of it like this: Do you remember as a kid having the jumbo pack, 64-count crayons box? Each crayon was a different color. Well, the S&P 500 represents one color or asset class out of that entire box. Many people may think the S&P 500 index provides a highly diversified portfolio, but it does not.
It does not represent asset classes such as small-cap companies, mid-cap companies, value stocks, growth stocks, emerging markets, international markets or global markets, along with a host of other markets too numerous to name in this article. Each of these asset classes is like a different color in the crayon box.
At Strategic Estate Planning Services, we believe in using many asset classes to create a highly diversified portfolio. Using the analogy of the crayon box, we believe in using many of the colors in the box versus just one color.
In a highly volatile market, it's the highly diversified portfolio that helps to mitigate the risk. The goal of diversification is to spread out invested assets among a wide variety of holdings to reduce the chances of losing money should one investment, asset class or sector drop in value. Not only can diversifying help manage risk, but it also offers opportunity for growth even if other portions of the portfolio decline.
To build a diversified portfolio, it is key to combine investments whose historical returns have not moved in lockstep together. For example, when stocks outperform, different types of bonds may underperform, and vice versa. This strategy helps provide the opportunity for continued growth in some portion of the portfolio with the goal of offsetting declines among other assets. If everything works according to plan, the total portfolio is less likely to suffer significant loss. Diversification has long been recognized as a risk-management tactic for retirement portfolios. In fact, the Employee Retirement Income Security Act of 1974 mandates that fiduciaries who manage retirement assets diversify plan investments in order to minimize the risk of extensive losses.
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Math Tells Us Why This Is Important
The more you lose, the bigger the gain you will need to make up for the loss. For example, a portfolio that has decreased in value by 5% will have to post a 5.2% gain to recover its original value. A portfolio that has decreased in value by 20% will have to post a 25% gain to recover. A portfolio that has decreased in value by 35% needs to achieve a 54% gain to recover. A portfolio that has decreased in value by 50% needs to achieve a 100% gain to recover.
The belief that the S&P 500 is usually the best performing equity index is a misconception, which is obvious when you look at a mid-year 2018 report from Sterling Capital Management LLC. The report shows from 1998 to 2017 that 50% of the time the S&P 500 outperformed the international markets and the other 50% of the time the international markets outperformed the S&P 500. This is exactly why we are not trying to duplicate the return of the Dow Jones or the S&P 500: One year it's on top, the next year it's not. Focusing on one index is too risky. In fact, based on a Riskalyze software score, the S&P 500 index equals a 78 on a scale of 1 to 99. The higher the score, the higher the risk.
A study conducted by Morningstar revealed that, over time, the average performance of an investor prone to buy and sell based on market conditions tended to trail that of a well-balanced buy-and-hold investor. Why? Because no one has a crystal ball that works and can predict what sector, asset class or index will perform the best in any given year. Investors who buy and sell often may be trying to chase a return from a given sector, asset class or stock, and that is very hard to do. The typical question is, "How do you know when to get in and when to get out?" Advisers often suggest a well-balanced highly diversified portfolio because not all sectors, asset classes or indexes will perform the same in any given year. A well-balanced, highly diversified portfolio may not capture all of the gain but it also may not capture all of the loss, and that is a key point to remember when market volatility begins.
Rebalance and Assess Any Overlaps in Holdings
While spreading out investments across a wide selection of financial products offers the benefits of diversification, recognize that this is not a one-time event. You should monitor the progress of all your financial assets to help ensure they stay on track to meet your goals. Because market returns often throw a prescribed asset allocation strategy out of whack, you should maintain the mix of asset class percentages aligned with your tolerance for risk, and don't be afraid to periodically rebalance your assets (sell outperformers) to retain your strategy.
Also, you will want to assess your diversification strategy across all your investment accounts (e.g., 401(k), IRA or investment portfolio, etc.) to ensure that many of your holdings do not overlap -- which can negate the benefits of diversifying. It is generally a good idea to work with a financial adviser to help you keep track of all the moving parts in your financial portfolio.
The Bottom Line
Don't measure the performance of your portfolio by looking at the Dow Jones Industrial Average and the S&P 500 indices. They are not the same by design, and that's a good thing. I recommend a highly diversified portfolio to help mitigate potential losses.
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Investment advisory services offered through AE Wealth Management, LLC (AEWM). AEWM and Strategic Estate Planning Services Inc. are not affiliated entities.
Neither the firm nor its agents or representatives may give tax or legal advice. This article was written for informational and entertainment purposes and should not be construed as advice designed to meet the particular needs of an individual's situation. The topics discussed may not be appropriate for all individuals and cannot guarantee specific results. "Advisor of the Year" is an annual award given by "Senior Market Advisor" magazine. Nominees must meet certain criteria relative to experience, sales volume, background check and community involvement. The winner is chosen by editors who are not clients of Mark Pruitt or Strategic Estate Planning Services. The award is not representative of any one client's experience and is not indicative of future performance. Hypothetical examples were provided for illustrative purposes only; they do not represent real-life scenarios and should not be construed as advice designed to meet the particular needs of an individual's situation. Investing involves risk, including the potential loss of principal. 644364
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