It has been well documented that the S&P 500 index fund has outperformed the vast majority of actively managed funds historically. Having said that, it may not be a prudent strategy to put everything in the S&P 500.
A Look Back at 2000
Imagine it is late 1999 and you just inherited $100,000 that you would like to invest. You’ve watched people well beneath your level of intelligence make a fortune on tech stocks the last few years, but you are wise and know it is an unsustainable path. You decide to do some research on your own rather than get involved in the tech mania.
You begin reading books about investing by a fellow named Burton Malkiel, and another named John Bogle. Their arguments are convincing and loaded with evidence that simple broad based index funds are the best long-term path for an investor.
After tinkering for countless hours over different types of allocations and fund combinations, you decide simplicity is best for you and that on January 1st, 2000 you will invest everything in a fund that tracks the S&P 500 index. The S&P 500 index is a stock index of 500 of the largest U.S. companies. Knowing that, you assume owning 500 different companies is well diversified, plus you’ve read that the S&P 500 has beaten most other funds.
After the first year you’ve seen your portfolio drop 9.10%. “No big deal” you think. You know that markets can have a bad year as you are well aware of market history. You remember from your readings that it’s best not to panic but rather ride out the storm. “The market always trends higher over time” you remind yourself. You feel a bit better about your 9.10% portfolio drop after hearing how much your friends lost in internet stocks.
Year two is over, and now your investment has dropped an additional 11.89%. The original $100,000 you invested is now worth only slightly more than $80,000 at the end of 2001. “This sucks!” you think. “I could have bought a 5% CD instead. I knew the market was overvalued. I am so unlucky….” you tell yourself as you begin the second guess your decision to invest in the first place. But you remember Bogle said it would be hard at times to hang on, so you bite the bullet and decide to see what happens in year three.
2002 has ended and your investment has now dropped an additional 22.10%. Now the original $100,000 you invested three years ago is only worth $62,392! You have serious doubts about your investment plan.
Three years have gone by and you have lost nearly 38% of your money. You understood that only long-term money should go into stocks, but you thought three years was a long time. You’ve stubbornly committed to hang on to this investment as long as you are able, because you do not want to sell at a loss.
By the end of 2006 you are finally in positive territory. Your $100,000 original investment is now worth $108,000 as you have eeked out a 1.13% annualized gain over 7 years (you actually lost 1.50% a year after inflation is factored in). You decide to cash it in and run. A few years later, you are quite happy you sold when you did, as the S&P 500 declined 37% in 2008.
Diversification Is More Than Owning A Large Number of Stocks
It’s true that from 2000-2009 the S&P 500 lost 0.90% annually.
What happened here? The investor got many things right……they did not get caught up in the tech bubble, indexing has shown to be a good way to invest, simplicity is important, buying and holding has shown to be a great strategy, but they did assume they were well diversified, which they weren’t.
It may seem like the S&P 500 is a well diversified fund to own. There are 500 different companies, across many different sectors and industries, and they represent many of the largest companies in America. But the United States only represents about half of the global stock market. Further, having everything in the S&P 500 Index only gives you exposure to one risk factor, which is referred to as market beta.
A More Diversified Approach
A more diversified approach is to own global stocks across many different countries, currencies, and risk factors like the company’s relative price, size, momentum, and profitability. This is the approach I implement using funds from various providers like DFA, Avantis, Ishares, and Vanguard.
The DFA Balanced Equity Index is a good representation of what I would consider a well diversified portfolio (although the portfolios recommended through Meredith Wealth Planning will differ). During the exact same 2000-2006 period the DFA Balanced Equity Index returned 13.66% annually, as opposed to the 1.13% annualized return for the S&P.
Is the story I told above a realistic one? Not really. I do have the benefit of hindsight now of course and I was not screaming from the rooftops in the year 2000 for people to be better diversified, I was 11 years old. But like most financial professionals I am picking data that helps prove my point, which is that even a decent strategy can have very tough times.
If the investor had started the same scenario owning just the S&P 500 in the year 2009, they would have been extremely pleased by the end of 2018, making over 13% annually while the DFA Balanced Equity Index would have been 12.25%.
If you look at the full period from 2000-2018 the S&P 500 index earned a total return of 4.86% annually, while the DFA Equity Balanced Index returned 8.32% annually.
Disclosure: Past performance does not predict future results. This article is for informational purposes only and should not be considered a recommendation. Information contained in this article is obtained from third party resources that Meredith Wealth Planning deems to be reliable. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.