A Friend Asks: Do you beat the S&P 500?

October 3, 2024

A friend struggling as a DIY investor asked if my firm outperforms the S&P 500, which led to a conversation about how exactly advisors add investment value and how our value proposition includes more than portfolio management.

A good financial advisor:

  • Helps you identify and prioritize goals
  • Builds you a financial plan and manages your money to accomplish those goals
  • Keeps you from making investment mistakes that hurt returns
  • Gets you to save and invest more
  • Organizes your finances
  • Helps you capitalize on financial opportunities and implement risk management strategies

It’s Not About Beating The S&P 500

Your goal shouldn’t be beating the S&P 500. The competitor in me hates writing this because it feels like downshifting expectations, but that’s not it. You need to turn your human capital into enough financial capital to fund your family’s future, so your goal should be to earn the returns necessary to do so.

Here’s an example why focusing on a benchmark is misplaced.

I’ve been an advisor since 2001, and the stretch from 2000-2009 was quite different than 2010-2019.

You could have beat the S&P 500 in the first decade and still made no money. 

You could have underperformed the S&P 500 in the second decade and earned more than stocks have historically averaged.

Where would you rather be?

What happens to your retirement in time periods when the S&P 500 doesn’t deliver, like it did during the lost decade?

Do you want to assume the S&P 500 won’t be flat again, or that its investment outperformance will continue? 

More importantly, do you want to bet your retirement on it?

To avoid that risk, you need a portfolio that looks different than the S&P 500, which means you shouldn’t be comparing yourself to it.

Fine, but Investment Performance Matters

I get it. Saying it’s the wrong question and ducking it is presidential debate-level evasion. But advisors can’t share their track records like institutional money managers can. This benefits clients, because choosing on past performance is a poor strategy. 

But I’ll say this, if all your advisor did was get you benchmark returns, you’d have an above average portfolio and would likely be doing better than you could on your own.

The Index Return Isn’t Average

People mistakenly believe that the index return is average, so to be above average you must beat it. Using the S&P 500 as an example, “only 27.1% of actively managed funds benchmarked to the S&P 500 beat it” according to The Wall Street Journal. 

The median large cap fund benchmarked to the S&P 500 underperforms, so the market return is a win to some advisors. That may seem odd, since you could buy the index fund(s) and do just as well on your own, but investors haven’t been able to.

The Investor Return Gap

Investors underperform their own investments, even when using index funds.

Morningstar’s 2024 Mind the Gap study shows that “the average dollar invested in US mutual funds and exchange-traded funds earned 6.3% per year over the 10 years ended Dec. 31, 2023. That is approximately 1.1% per year less than the average fund’s total return over the same time period assuming an initial lump-sum purchase. The 1.1% ‘gap’ is explained by the timing of investors’ purchases and sales of fund shares.”

I’ve written about this here, including what causes the gap, which fund types hurt investors the most, and how to avoid it. 

A good advisor can close this gap, according to Vanguard’s Advisor Alpha which estimates that behavioral coaching can add up to 2% of value for clients by preventing the mistakes highlighted in Morningstar’s research.

Putting More to Work: Minimizing Cash Drag and Saving More

Advisors can also add value by helping you save more and investing your excess cash.

The first part builds up a bigger nest egg by exposing more money to the market’s long-term return and compounding effect. 

The second part addresses the fact that people have too much portfolio cash.

  1. The American Association of Individual Investors (AAII) regularly publishes an Asset Allocation Survey showing its members’ stock/bond/cash allocations. Going back to 1987, the average portfolio cash allocation is 22.2%.
  2. Vanguard has a study looking only at 401(k) allocations, where you would expect less cash, and the average cash allocation has been 8.7% for the last ten years. 
  3. Vanguard analysis shows that the average IRA has about 10% invested in cash.

A good advisor puts your cash to work. I’ve written about cash drag being a top investing mistake and shared an example where reducing it could improve returns by .67% return per year.

Fees and Taxes

Two other things touched on in the Vanguard Advisor Alpha framework are the ability to access cheaper institutional investments and investment tax-planning to increase your after-tax return through tax-loss selling and asset location.

Wait…There’s More

Advisors also provide accountability and the technical knowledge to:

  • Make sure you have an up-to-date estate plan
  • Maintain adequate personal liability, disability and life insurance
  • Evaluate your employer benefit options
  • Assist with annual tax planning with your tax preparer and review your return annually for missed opportunities
  • Build a detailed financial plan to make saving, retirement, and other decisions
  • Be a sounding board to navigate financial differences of opinion between you and your spouse or partner and help with key decisions
  • Help with major life transitions like moving, job loss, passing of a family member

Final Thoughts

As Scott Galloway said in his recent book, The Algebra of Wealth: A Simple Formula for Financial Security: 

Here’s the critical thing about advisors. You aren’t paying them for investment returns. Over the long term, nobody beats the market. And if someone does have the secret to above-market returns, they aren’t going to be sharing it with you for a fixed percentage. You’re paying an adviser for planning, accountability, and confidence. The more wealth you accumulate and the more complex your life gets, the more valuable these services become.

There’s more to it than this as I’ve tried to show, but Galloway gets it more than most.

Further Reads

Finding a Good Financial Advisor