How Advisors Can Help Clients Think Beyond the S&P 500 as a Benchmark

For many investors, the S&P 500 has become synonymous with the stock market. But many don’t truly know what it is or whether it’s an appropriate barometer against which to measure their portfolios.

The reality is that the S&P 500 is just one of many investment benchmarks financial advisors can choose for their clients. And except for investors with an extremely high tolerance for volatility, it may be one of the worst benchmarks for clients to use.

That’s because the S&P 500 is, in reality, nothing like what many investors think it is. It has its own quirks and blind spots that make it inappropriate for some clients to chase.

As a financial advisor, do you have the courage to explain this concept to clients? It means going against an unprecedented headwind of popularity in that market benchmark. But the answer may just determine what your clients think of you in the not-too-distant future.

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The Popularity of the S&P 500

Investing in mutual funds, exchange-traded funds and alternative products that revolve around the performance of the S&P 500 has become something of a national investor pastime.

Psychologically, that makes a lot of sense. Investors typically want to own what they wish they had owned last year — or for the past several years.

With the S&P 500 rallying about 100% from the coronavirus-pandemic-induced bottom of March 2020, you probably have clients looking at you wondering why you can’t provide them with the kind of returns their friends are allegedly getting elsewhere.

[Read: Advisors: Is It Time to Adjust Your Investing Strategy?]

What’s Inside the S&P 500

Since many of your clients may not understand how the S&P 500 really works, here’s what to explain to them.

First, while the S&P 500 does indeed contain about 500 stocks, six of them make up nearly a quarter of the index’s current weight. You can probably guess which ones dominate: They are Microsoft Corp. (ticker: MSFT), Apple Inc. ( AAPL), Amazon.com Inc. ( AMZN), Facebook Inc. ( FB), Google parent company Alphabet Inc. ( GOOG, GOOGL) and Tesla Inc. ( TSLA).

The S&P 500 is weighted by market capitalization, so the largest stocks carry the greatest weight. Investors can look at that as owning the most successful, prominent businesses. Or they can view it as buying yesterday’s winners.

After all, the index favors what did well in the past. When fortunes reverse, it can distort the index in the opposite direction. Clients may think they are diversified, but 450 of those 500 stocks don’t impact the S&P 500 much.

Similarly, the S&P 500 is currently dominated by six of its 11 economic sectors. Those six sectors comprise nearly 75% of the index. The top-heaviness of the index was squarely at the root of the market collapse during the dot-com bubble in 1999 and 2000 and led to a mirror-image market scenario. That means the former market leaders became some of the worst performers within the S&P 500.

The current rally could last several more months or years. Or it could collapse quickly — and soon. But you don’t control that, so your best choice is to be proactive in educating clients who are heavily invested — or want to be — in the S&P 500.

[Read: How Advisors Can Succeed, Even in Bear Markets]

S&P 500: Past Performance

Educating your clients about the downside risk of the S&P 500 can include mentioning the composition issues discussed above. But that is likely to fall on deaf ears.

Investors tend to judge with their eyes. And right now, their eyes are focused on the S&P 500.

Further education starts by acknowledging the success of the S&P 500, then describing the more complete history of that popular investor target.

The S&P 500 may have a reputation for solid long-term returns, but those performance results have come with a level of volatility that many moderate-risk and conservative investors say they do not want.

Any investors who says they cannot afford to see a 40% to 50% portfolio drawdown multiple times along the way should simply not be comparing their portfolio results to the S&P 500. As investors saw recently, it takes one major event — like the coronavirus pandemic — to quickly wipe out any gains an investor has accumulated over years or decades of tracking the index. And the S&P 500 does not always bounce back as easily as it did in that case.

Markets are, if nothing else, cyclical in nature. That means you need to remind clients of the extreme times investors are living through. It follows that during such an era in investment history, doing what is currently popular leaves them vulnerable to coming down from the high of the past 18 months.

More to the point, pining after S&P 500-like returns, or anything approaching them, likely represents a significant drift away from what they hired you to do in the first place: That is, to earn returns that allow them to reach tangible, real-life goals.

Long-term gyrations and large best-worst ranges are not likely to deliver that for them. In particular, consider the proverbial bullet the S&P 500 dodged in 2020. If the market had not experienced perhaps the most unprecedented “bounce” in history, starting in March 2020, someone who spent 20 years relying on that index for their retirement would have seen one-third of everything they built vanish in a matter of five weeks.

Is that something your clients will be OK with? And even if that never happens again, does that mean it is the type of risk they want you to pursue for them?

S&P 500 Alternatives Advisors Should Consider

At a time when reward is top of mind and risk of major loss is shuffled to the back of clients’ investment consciousness, it is your moment to be the voice of balance and forethought.

So, what are some more realistic benchmark alternatives?

The list is long, and since you likely encounter and serve a wide variety of investor types, here is a short list to start with.

— S&P Target Risk Conservative Index

— S&P Target Risk Moderate Index

— S&P Target Risk Growth Index

— S&P Target Risk Aggressive Index

— S&P 500 Equal Weight Index

— MSCI World Index

— Russell 3000 Index

Preparing a slate of indexes, some stock-oriented and some risk-oriented, can be a helpful exercise. That allows you to rank them over different time periods, or via a best-worst type of presentation, and show your clients where their own performance fits into that list.

One thing to keep in mind about many of these indexes is that their stocks are market-capitalization weighted. That means they are all susceptible to the top-heaviness of many such indexes. This has developed over time as index investing took in so much investor capital. That created a self-fulfilling prophesy, where the index’s largest components get much of that cash, forcing their stock prices up and up.

This exercise is particularly useful when it comes to the risk indexes. For instance, showing a moderate-risk client that their numbers compare closely with the moderate benchmark, and that moderate investors are earning nowhere near the S&P 500 since that index bottomed early last year, helps reinforce that your focus is on their mission.

One other approach for risk-averse clients who suddenly want to chase the S&P 500 is to explain that your approach is more of a bottom-up one than a top-down one. Specifically, if their goal is to earn a competitive return versus what bonds used to provide (but no longer do in an era of low interest rates), focusing on their return above bonds instead of how much less than the S&P 500 they are making is a more realistic comparison.

Advisors can be proactive client educators by converting client emotions and assumptions into valuable teachable moments. Or you can risk being on the wrong side of history when the market cycle eventually reverses, as your clients are left wondering why you didn’t try harder to push back against their worst instincts. Tackle the FOMO, or fear of missing out, head-on, rather than catering to it. Your practice’s long-term value might just depend on it.

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How Advisors Can Help Clients Think Beyond the S&P 500 as a Benchmark originally appeared on usnews.com

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