Why the S&P 500 Is Probably the Wrong Benchmark for Your Portfolio (EP.266)

0:21Welcome back to The Long-Term Investor. Today, we are talking about benchmarks and why a perfectly sensible portfolio can feel like a failure when you measure it against the wrong thing. Benchmarks measure performance and shape what performance feels like. When the benchmark doesn't align with what you own or what you're trying to achieve, regret can become the default reaction even when the plan is working. There's a story I always tell about when my family goes to Michigan, something that we've done for more summers than I can even count. We'll spend these long days by the water, eat slow dinners, and then we walk to the corner market for ice cream every night.

1:02But there was one year I was on a strict diet and I limited myself to one ice cream cone for the whole week. And by the time it arrived, I had been dead set on getting cookie dough ice cream. But as I stepped up to the counter, everyone around me started campaigning for Mackinac Island fudge. You have to get it, they said. It's the best. I changed my order at the last second, and the cone was fine, but I spent most of it thinking about cookie dough ice cream. And for the rest of the week, I watched everyone else order exactly what they wanted, including cookie dough, more than once. The regret was small, but it lingered.

1:42With investing, the stakes are obviously higher, but regret shows up as that same sinking feeling tied to the road you did not take. With investing, the stakes are obviously higher, but regret shows up as that same sinking feeling tied to the road you didn't take. The choice that looks better after the fact. As we discussed a few weeks ago in episode 262, hindsight bias edits the past. After an outcome is known, the earlier uncertainty fades and reasonable decisions start to look like obvious mistakes. You can see exactly what the S &P 500 did over the last decade, and you can pull up the fund you didn't buy or the strategy you dropped right before it recovered.

2:29Every line on a graph becomes a version of cookie dough ice cream that you passed up. And every what-if has a data series. Many investors never choose a benchmark on purpose. They end up absorbing one like the S &P 500 because it appears everywhere, from news coverage and phone apps to conversations with friends and family. Over time, it becomes the yardstick for everything, even when it doesn't match the strategy they own. There's nothing wrong with the S &P 500 as a benchmark for U.S. large-cap stocks. The problem begins when it's used to judge a portfolio it doesn't represent. Because many diversified portfolios include international stocks, small-cap stocks, bonds, cash.

3:17A narrow U.S. large-cap index doesn't measure that whole picture. Short-term comparisons add another problem. Because over six months or one year, results are heavily influenced by noise and events no investor could reliably anticipate. Basically, a well-chosen benchmark keeps you from changing a portfolio that's working simply because it trails an index built to measure something else. So what makes a good performance-based benchmark? The CFA Institute describes a seven-part test for a valid benchmark that can be remembered using the acronym SAMURAI. Now, I'm going to take the traits one at a time and apply each to a real example.

4:00the net return version of the MSCI ACWI index measured in U.S. dollars. Now, ACWI, A-C-W-I, stands for All Country World Index. It includes large and mid-cap stocks from developed and emerging markets, covering about 85 % of the investable global stock market. We are going to evaluate ACWI as a benchmark for the global equity portion of a portfolio, but not for the entire balanced portfolio that perhaps also contains bonds and cash. So the first trait in Samurai, the letter S, stands for specified in advance. So a benchmark works when it's chosen before the outcome is known. Unfortunately, investors often do the opposite.

4:44They will look back and grab whichever comparison looks most attractive. The second letter in Samurai, A, stands for appropriate. and an appropriate benchmark reflects the portfolio's intended assignment. MSCI ACQUI represents broad, global, large, and mid-cap equities rather than one country or investment style, making it a very reasonable benchmark for a diversified global stock allocation. Now, if the portfolio includes a meaningful small-cap allocation, the MSCI ACQUI IMI, or the Investable Market Index version, might be more appropriate just because it extends coverage to small companies and roughly 99 % of the global equity opportunity set.

5:25The next one is measurable. A benchmark must produce a return that can be consistently calculated and tracked over time. If we're looking again at measuring MSCI ACQUI, that meets the standard because its returns and fact sheets are publicly available and regularly reported. Unambiguous. The next one is an unambiguous benchmark is explicit about what it holds and how it's built. It should also identify the currency and return convention being used. So looking at MSCI ACWI, MSCI publishes the index methodology, including what qualifies for inclusion, how securities are weighted, and when the index is reviewed.

6:06And one quick technical note, in this example, we've been using the net return version that is measured in U.S. dollars. And net return just means that dividends are reinvested after withholding taxes assumed under MSCI's methodology. Now, this is a pretty common benchmark, but you've maybe never really understood what that net return is. So it does not mean the return is net of fund expenses, advisory fees, or every tax an individual investor might owe. But that is sort of what it means. Now, this sounds very similar to measurable, but measurable asks whether you can observe the result, unambiguous asks whether everyone is measuring the same thing.

6:46So hopefully that helps kind of clarify two things that sound pretty similar. The next one in Samurai R is reflective of current investment opinions. So when we talked about appropriate, that was asking whether a benchmark fits the portfolio's assignment, whereas reflective asks whether the benchmark securities and factor exposures are familiar enough that you can form a view about them. So if you're an individual investor, as I suspect most of you are, I'd translate that as understanding the benchmark's major exposures and how it is constructed, not necessarily knowing every company it owns. So if we're talking about the MSCI ACWI, those exposures include market cap weighted, large and mid cap stocks across developed and emerging markets.

7:33The A next is accountable. So accountable means accepting the benchmark as a fair test and taking responsibility for explaining the portfolio's departures from it. So if you only like the comparison when you're winning, it isn't really a benchmark. It's more of a mood ring. And so specified in advance is about when you choose the benchmark. Accountable, the one we're on right now, accountable is about continuing to accept it after the results arrive. With the MSCI ACWI, accountability means being able to explain intentional departures such as country, size, or factor tilts, and continuing to accept ACWI as the standard even when those departures underperform.

8:16Lastly, we have I, and it stands for investable. Investable means that the benchmark represents a feasible alternative an investor could have reasonably pursued. You cannot buy an index directly, but investors can own index funds and ETFs that seek to track the MSCI ACWI, and that makes it a realistic alternative rather than a hypothetical portfolio no one could have owned. When the benchmark passes the samurai test, the conversation around performance changes. The question of why didn't I beat the S &P 500 gives way to questions that fit the portfolio. For example, given the strategy I chose, is this a reasonable result?

9:00Does my performance reflect choices I made on purpose? How much risk did I take relative to this benchmark? In my opinion, those questions shift the focus from ego to process. A performance gap becomes a prompt to identify its source, intentional allocation choices, cash, fees, implementation, or drift, before deciding whether anything needs to change. Outperformance deserves the same scrutiny. Did it come from skill, luck, or taking more risk than planned? This kind of review reduces performance chasing, but comparisons also need to be made at the right level. One common trap that I see all the time is judging an individual holding as though it were the entire portfolio.

9:50So think about this. You open your account, you spot the laggard, and you wonder, why do I still own this? And I see this happen all the time with anything that isn't one of these kind of headline indexes like the S &P 500. So it could be a small cap fund or a value fund or international or maybe some kind of bond fund. And the problem, in my opinion, is role confusion. For example, a small cap fund gives you exposure to small companies and a value fund tilts towards cheaper stocks. An international fund, as you probably understand, diversifies beyond one country. and a bond fund provides stability or income or dry powder for rebalancing.

10:31So none of those were hired because, again, you're hiring a manager here, and none of them were hired to behave like the S &P 500. So I think the calmer, more reasonable approach is to group holdings by its job. Evaluate a fund or sleeve against a benchmark appropriate to its role. Then, you can evaluate the combined global equity allocation against a global stock benchmark such as MSCI ACQUI. And then finally, I think you can evaluate the entire stock and bond portfolio against a blended benchmark, reflecting its strategic allocation. In my opinion, that framing makes it easier to tolerate an out-of-favor sleeve that is doing its job and to identify one that is not.

11:17It's those comparisons that will tell you whether each component and the whole portfolio behaved as intended. But even the right performance benchmark cannot answer the question investors ultimately care about most. Are we still on track to meet our goals? Really another way of asking, am I still going to be okay? A performance benchmark can't answer that. It really can only tell you whether the portfolio behaved as designed. A goals-based measure, though, not a benchmark in the same technical sense, but it helps assess, under the assumptions being modeled, whether the plan remains on track to fund the life you want.

11:58Goals-based measurement deserves a separate episode, so for now, let's just remember that the perfect portfolio earns what it needs to earn and gives you enough clarity to stay invested, even when a mismatched yardstick makes the plan feel like a failure. Pick your ice cream flavor before standing at the counter and measure success against a life you recognize as your own, not someone else's scoreboard. If you enjoyed today's episode, the content was derived from my new book, The Perfect Portfolio. You can sign up at the top of the episode description or visit theperfectportfoliobook.com and you will get exclusive updates, subscriber-only webinars, and all sorts of other good stuff.

12:42Again, you can use the link at the top of the episode description or go to theperfectportfoliobook.com. As always, thanks for listening and until next time. to long-term investing.

13:23and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.