As the S&P 500 index and the Dow Jones Industrial Average (DJIA) reached record highs through the third quarter of this year, many investors are asking: “Why isn’t my portfolio keeping up with the stock market?” This is a good question, and one that requires an informed perspective and proper context to adequately address. After all, it’s natural for investors to feel frustrated when their portfolios do not keep pace with the market, particularly when the market is on a hot streak.
A good place to start is by evaluating whether we should be comparing our portfolio to the S&P 500 or the Dow as the benchmark or baseline. The S&P 500 represents 500 of the largest publicly-traded corporations in the U.S. The Dow Jones Industrial Average - often referred to as simply “the Dow” - represents 30 large American publicly-traded companies. While both have seen record highs through the end of September 2018, these indexes are only an appropriate measure of comparison if your portfolio consists solely of large U.S. company stocks. In other words, if your portfolio also contains bonds, international stocks, or commodities, then the composition of your portfolio is not suitable to compare with the S&P 500 or the Dow.
What can help explain why my portfolio isn’t keeping up?
The answer comes down to one word: Diversification. Diversification is a technique that mixes a variety of investments within a portfolio to help ensure investors don’t put all their eggs into one basket. Because different investments rise and fall at different times, diversification helps smooth the overall investment experience for the investor.
A well-diversified portfolio will include stocks of all sizes, such as large and small cap, as well as international companies, both in developed markets like Europe and emerging markets like China and India. In addition to stocks, a diversified portfolio would also include a variety of bonds, including government, corporate and international bonds. There may also be allocations to commodities, such as cash and real estate. The S&P 500 and the Dow track only one of these categories and is therefore not representative of all the ingredients in a diversified portfolio. Of course, diversification does not ensure a profit or protect against loss.
What if I want to get decent returns and limit the downside?
Many pre-retirees and retirees have moved portions of their portfolios into fixed indexed annuities as a means of diversification and to limit risk. Fixed indexed annuities which are commonly referred to as FIAs, are fixed annuities with a feature that links a portion of the annuity to the performance of an external index.
One of the most common indexes used is the S&P 500. There are many other indexes based on the Russell, the Nasdaq, the Bloomberg U.S. Balanced Index and many others. For example, had you been invested in a FIA from September 30, 2017 to September 30, 2018 that was linked to one of those index options, you may have locked in a return as high as 8% or so, net of fees. During the same period if you were in the market invested in an index mutual fund of S&P 500 companies, you would have had a return of approximately 15%. However, that 15% return was not locked in.
Fixed indexed annuities come in various shapes and sizes and should not be confused with variable annuities. While variable annuities can be a reasonable choice for some, be aware that the costs associated with variable annuities can generally range between 3%-5%. Index annuity fees range from 0% to as high as 2.5%, though most fall in the range of 1.5%. Be sure you work with a fiduciary who can help explain these somewhat complicated, but compelling investment choices.