You’ve done your homework, run the data, performed your due diligence and built a diversified, multi-asset portfolio for your client. But your job isn’t done.
All advisors know that clients may act surprised and disappointed when their portfolios get a little crazy. Naturally, it’s nearly always the downward volatility that bugs them the most. But experienced investors will also be wary of persistent periods of overperformance, knowing that what goes up must come down.
The tricky part is educating your client on how to recognize what constitutes underperformance and overperformance. To this end, it is vital that an advisor explain to a client — and help them understand — that the performance benchmark for their portfolio is NOT the S&P 500, despite the fact that the index is widely reported and often cited as a representative return of the stock market.
Start off by asking yourself a simple question: “What’s a reasonable performance expectation for an investment portfolio?” A simplistic approach would be to default to the S&P 500. After all, the average three-year rolling return of the S&P 500 from 1970 through the end of 2019 has been 10.95%. There were 48 rolling three-year returns between 1970 and 2019. The first three-year period extended from 1970 to 1972. The next was from 1971 to 1973, and so on.
So far so good. But now the tricky part: How do we determine how often the S&P 500 delivers performance close to that average three-year return of 10.95%?
To tackle this question, I’ve imposed upside and downside performance bands of 500 basis points around the S&P 500 mean three-year return of 10.95%. This creates an upside performance limit of 15.95% (10.95% plus 500 bps) and a downside performance limit of 5.95% (10.95% minus 500 bps).
As shown in “Where’s the mean?” a portfolio that mimicked the S&P 500 was outside of the 500 bps upside and downside limits 52% of the time — 25 of the 48 rolling three-year periods from Jan. 1, 1970, to Dec. 31, 2019. (The 500 bps performance bands are shown as red lines on the graph.)
In other words, 52% of the time the all-equity investment portfolio produced three-year returns that were more than 500 bps above or below the mean three-year rolling return of 10.95% (shown by the dash line on the graph).
Also as shown in the graph, the return in the most recent three-year period from 2017 to 2019 was 15.27% — just below the upper limit of 15.95%. The previous three-year return from 2016 to 2018 clocked in at 9.26%. That’s a sizable difference between two adjacent rolling three-year periods. The 2016-2018 period was below the mean three-year return of 10.95%, and the 2017-2019 return was well above the mean.
Yet those performance differentials are child’s play compared with earlier time periods. For instance, the three-year return for the S&P 500 at the end of 1999 was 27.56%. By the end of 2002, it had plummeted to -14.55%. A single asset-class portfolio — such as 100% large-cap U.S. stock — clearly produces performance whiplash.
Where’s the mean?
Now let’s consider the rolling three-year performance of a hypothetical multi-asset portfolio that includes seven equally weighted indexes covering the following asset classes: large-cap U.S. equity, small-cap U.S. equity, non-U.S. equity, real estate, commodities, bonds and cash. (See the graphic: “Mean hugger.”)
This diversified, multi-asset portfolio has a 43% allocation to equities, a 28.5% allocation to diversifiers (real estate and commodities) and a 28.5% allocation to fixed income. Thus, in sum, it has a 72% allocation to “performance engines” and a 28% allocation to “safety brakes.” This diversified investment portfolio (with annual rebalancing) generated a mean three-year rolling return of 9.83% — which was below that of the 100% equity portfolio.
Worth noting, however, is the relative consistency of the three-year rolling returns. In only 42% of the periods — 20 out of 48 rolling three-year rolling periods — was the portfolio return more than 500 bps away from its mean return (shown by the dash line in graph 2). Importantly, when the portfolio did exceed the upside or downside 500 bps bands, the deviation beyond the limit was quite small — something that can’t be said of a 100% equity portfolio.
The average gap between the mean three-year return of 10.95% and the 48 individual rolling three-year returns for a 100% S&P 500 investment was 732 bps. Put differently, the average distance between the dash line in graph 1 (the average three-year return of 10.95%) and the blue line (the rolling three-year returns) was 732 bps.
By comparison, the average distance between the mean return of 9.83% and the 48 individual rolling three-year returns — represented by the maroon line in graph 2 — for a diversified seven-asset portfolio was 449 bps. In other words, a diversified portfolio produces performance that is closer to its mean return. Or in still other words, a diversified portfolio will have a lower standard deviation of return — which is a primary reason to build diversified, multi-asset portfolios.
Note also that the multi-asset portfolio had only three rolling three-year returns that fell into negative return territory. They occurred 2006 to 2008, 2007 to 2009 and 2008 to 2010. Not surprisingly, 2008 was the common denominator in all three of these time periods. The three-year average return during those three three-year periods was -2.81%.
A portfolio consisting solely of the S&P 500 had a considerably less pleasant downside experience. Between 1970 and 2019, large-cap U.S. equity had eight rolling three-year periods with a negative return. The average return in those eight three-year periods was -6.3%.
Of course, there is a trade-off when building a diversified portfolio. You’ll notice that the multi-asset portfolio rarely had three-year annualized returns near the 20% level.
Conversely, the 100% large U.S. stock portfolio generated three-year returns close to, or above, a 20% three-year return on eight occasions.
Which market?
Armed with this knowledge, your task is now to convince clients that “the market” and the S&P 500 are not synonymous. To reinforce this point, I would suggest the following: When a client asks you how “the market” is doing, respond with the question, “which market are you referring to? Are you talking about the U.S. large-cap market, the midcap U.S. market, non-U.S. developed stock market, commodities market, bond market…?”
The bottom-line message to convey: Don’t buy into the common assumption that “the market” is represented solely by the S&P 500.
Rather, consider coaching your client to ask: “How is a broadly diversified portfolio doing these days?” To which you could answer, “Well, since 1970 a portfolio that contains equal portions of large-cap U.S. equity, small-cap U.S. equity, non-U.S. equity, real estate, commodities, bonds and cash with annual rebalancing produced an average three-year return of 9.83%.”
Having said all that, the S&P 500 is a perfectly acceptable benchmark for a client who has a portfolio consisting solely of large U.S. companies. But if your client’s portfolio includes a variety of asset classes, it’s crucial that an appropriate performance benchmark be identified and communicated to them from the start.
Failure to provide an appropriate performance benchmark for clients creates a situation where performance expectations become misaligned because the performance index being used by the client is not comparable to the asset allocation of their actual portfolio. In short, advisors must identify performance benchmarks that are congruent with the portfolios they are building for clients.
A multi-asset investment strategy and the courage to stick with it during up and down markets creates an investing experience for clients that has far less drama precisely because it will perform closer to expectations more often.
