Don't get swept away by 'S&P 500 envy' as stocks shatter records and bonds lag

By Beth Pinsker

Here's how to remind yourself that diversification still matters in the long run

When stocks are up and bonds are down, as they are now, it gets hard to convince investors that diversifying their portfolio with both types of investments matters. All they see is the line on their account statements that compares their return to the headline-making returns they hear about - namely that the S&P 500 SPX is up nearly 12% year-to-date in mid-May and the Dow Jones Industrial Average hit 40,000.

If it's less, they get what's become known as "S&P 500 Envy."

This hasn't been the case in the past few years when both stocks and bonds were down, but there were similar conditions to now in 2018 that fed the "S&P 500 Envy" concept. The investment company BlackRock (BLK) put together a presentation for financial advisers to incorporate into their talks with clients with this title. The goal was to show how investors generally feel about the years when the total return of their diversified portfolio is worse than the S&P, even if over time, they make more money. (BlackRock declined to comment for this article.)

In the core graphic updated for 2023, there's a sad face for 2000 to 2002, 2008, 2020 and 2022, when the S&P was down and the sample portfolio was down by much less. "I lost money," the hypothetical client thinks. There's also a tear shed for 2009 to 2019 and 2023, periods when the S&P was up significantly while the sample portfolio was up slightly less. "I didn't make as much," is the complaint. Over the whole time frame of the chart, the S&P was up slightly less than the sample client and the conclusion is that "diversification can work, even when it feels like it's losing."

BlackRock declined to comment.

Nicholas Olesen, a certified financial planner with Kathmere Capital Management near Philadelphia, incorporated this reasoning in a video presentation back in 2018, and also sees the same analysis applying today.

"We do have to advise diversification a lot harder when the S&P goes up for a long period," he says. "The common question that clients have is: Why would we do anything except the S&P? It's the one thing that's working."

Confronting recency bias

Olesen's counterargument for diversification starts with data showing that having a mix of investment types is best in the long-term because it hedges for the ups and downs of different economic components. "The S&P 500 index has been fantastic for five years now, but people forget there will be periods where other things work."

In the behavioral finance world, this is called "recency bias," which explains that investors tend to think the thing that happened last is going to always happen. So if they are bullish that the S&P is doing so well, they will ditch their carefully calibrated 60/40 portfolios and go all in on equities. When there are dips in a financial crisis, investors tend to pull out altogether, fearing a forever disaster.

Advisers perennially argue for long-term thinking and balance, setting up a portfolio with a ratio of stocks to bonds based on the investor's personal situation, and sticking with the plan despite turmoil.

"Diversification is not designed to give you the greatest performing portfolio right now; it's designed to give you the results you want long-term," says Olesen.

Ross Haycock, a certified financial planner with Summit Wealth Group in Colorado Springs, Colo. also uses this line of argument with clients, and his firm still posts about S&P Envy on its website. "You can go back to the old adage: Don't put all your eggs in one basket. It's timeless. Of course, there are times I wish my eggs were in a different basket, and sometimes, I say thank goodness I don't have them in that basket."

He says the diversification discussion goes over much better with the firm's longstanding clients, who have been through ups and downs with them for decades. "With our newer relationships, when you go through turbulence, there's a lot more hand-holding," he says.

Don't forget about bond yields

When investors balk at diversification, mostly what they are doing is shunning bonds, which have taken a consistent beating in the last few years. Vanguard's Total Bond Market Index ETFBND, for instance, was down 1.26% year-to-date in mid-May, and down 9.23% the past five years. But people tend to get caught up in the price of bonds, rather than the yield. On paper, if you have owned a diversified portfolio with a simple total stock fund and a total bond fund, you might not be very happy with that.

"If the bond market is down double digits, it would reduce your risk, but it would hurt you, in that time. People get caught up in returns, and forget those periods happen," says Olesen. But they also forget about yield. All that time you hold the bond fund, it's generating consistent, guaranteed yield, and the lower the price, the higher the yields, generally speaking.

That's why where you look on your account statement matters for this S&P envy component. People who take that quick glance and see that they are up only 1% for the day while they hear on the news that the S&P was up 2% aren't seeing all the context they need, and that drives their emotions. Olesen calls this "statement shock."

That snapshot number does not typically include yield, either on cash or fixed-income products like CDs and Treasurys, for one thing. It also will not likely include bond yields for long-term bonds, and other direct bonds. All the client will see is the red number on a down day, and they may not understand that it indicates the market value of that bond at that moment in time. If you hold the bond to maturity, it does not lose value, and it generates yield all along.

"You have to look at a good, time-weighted return performance number. Any good adviser has it," says Olesen. "You can get great yields right now. But if you're only looking at the price, you're definitely going to have a different view."

This underscores another point advisers repeatedly make when it comes to diversification: Make a plan and stick to it. You don't want to make rebalancing considerations based on one day of market information. That decision should be much more considered and reasoned.

"We're humans and we do get caught up in FOMO," says Haycock. "Don't let your emotions drive your financial decisions. Step back and think about it rationally. Most people then go yep, I totally understand why we are diversifying."

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05-25-24 1220ET

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