Why Trying to Beat the S&P 500 Is a Bad Idea

Kate Stalter

An advertisement on social media touts a trading product that is, apparently, beating the S&P 500 index.

The ad shows performance of the domestic large-cap index in 2018, as compared to the performance of this product. According to the data shown, the product had a better return last year.

Setting aside the highly unlikely scenario that buyers of the product were responsible for making all the right trades at the precise times, the question remains: Why is beating the S&P 500 even relevant?

[See: Beware of These 7 Blind Spots in Your Portfolio.]

Frequently, you'll see the S&P 500 described as the "benchmark index." The index measures performance of the 500 largest domestic public companies. Exchange-traded funds that track the index are widely held. The SPDR S&P 500 ETF (ticker: SPY), launched in 1993, was the first fund to track its namesake index, and the first ETF to trade in the U.S.

It currently holds about $286 billion in assets under management.

Because of the fund's long history and its popularity, it's understandable that investors might believe the S&P 500 is the most important index. That's compounded by home country bias, a term for a narrow focus on one's home-country investments. Morningstar research has identified this phenomenon among investors in several developed countries, including Canada, the U.K., Germany and Japan.

Home country bias results in American investors and financial reporters placing outsized emphasis on this index, as well as the Nasdaq composite and the Dow Jones Industrial Average.

Certainly, as the index that tracks the biggest U.S. companies, the S&P 500 is not to be dismissed. But neither is the importance of broad diversification, which is why the notion of "beating the S&P 500" is erroneous.

In most calendar years or quarters, there is some other asset class that outperforms the S&P 500.

In fact, U.S. investors don't even need to give up home country bias to find an asset class with a better year-to-date track record. Mid-cap growth stocks, which are not included in the S&P 500, advanced 3 5.9 % year to date, vs. 28.6 % for the S&P 500.

This may cause some investors to feel buyer's remorse, if they decided the S&P was the only necessary domestic investment. However, outperformance of mid-caps should not really be all that shocking, considering that stocks with smaller market capitalizations typically outperform their larger peers, over time.

Think of it this way: Say you want to improve your health, and you join a gym. You decide that a well-known, familiar exercise is all you need to do, so four times a week, you do bicep curls. Nothing but bicep curls.

Now, you might end up with some great-looking guns after a few weeks, but to what effect? Has that improved your overall health?

[See: Do Bull Markets Scare You?]

You've overlooked all your other muscle groups, both upper and lower body. You've also overlooked your core muscles. In addition, there's no cardio in the mix to improve your heart and lung health.

It's pretty easy to see how this analogy applies to investing. You're probably at least somewhat familiar with the S&P 500, and you've heard it called "the benchmark index." But why should a group of the largest U.S. stocks be a benchmark for broader market performance, any more than one muscle group should be the benchmark for your overall physical health?

Part of the focus on large U.S. stocks goes back decades, before other asset classes were widely available to retail investors. Before the widespread availability of ETFs, domestic investors were largely relegated to choosing from a handful of large-cap single stocks for their portfolios.

Buying a single foreign stock can still be difficult, and that's where funds come into the picture. Even buying a stake in a small U.S. company can be a bit daunting, as there is often little research into smaller firms, and there's often a lack of liquidity, as fewer shares are available.

Here again, mutual funds and ETFs allow today's investors easy access that previous generations didn't enjoy.

[See: 8 Things to Remember When Reviewing Your 401(k).]

So if you see some trading product or even an index being touted as having performance superior to the S&P 500, ask yourself a few questions:

-- Does that particular asset class outperform large-cap U.S. stocks over time?

-- Are you looking at comparisons of asset classes at all, or simply some trade suggestions, which, if executed perfectly, would have outpaced the S&P 500?

-- Why is it even important that one asset class outperform another, if your portfolio is allocated properly, to generate the return you need to meet your financial goals?

It all comes down to your financial needs, and your unique situation.

Just as in the gym, a focus on one particular area probably won't do much for optimal health.