There has long been a belief that the best way to get a good return on your money is to invest only in the S&P 500.
The reasoning is as follows: since the Standard & Poor's 500 (S&P 500) stock index is ahistory of outperforming active investors(such as mutual funds), the best investment approach for those who don't know much about the markets is to invest in a low-cost S&P 500 fund.
But this strategy is not a recipe for success. It can even lead to unwanted losses. Investors who invest only in the S&P 500 are exposed to several pitfalls:
- Investing solely in the S&P 500 does not provide the broad diversification that minimizes risk
- Economic downturns and bear markets can still cause big losses
- The past performance of the S&P 500 is no guarantee of future performance (yes, and we'll get to that!)
- You lose the benefits of investing in other developed and emerging markets, other asset classes such as REITs and small-cap companies.
While investing solely in the S&P 500 is better than an active investing approach (which also involves trying to time the market), it is still a losing strategy for the reasons mentioned above.
Before we get into the explanation of why investing in the S&P 500 is not just a sound investment strategy, let's briefly review what the S&P 500 is and why its appeal has grown to the levels we are witnessing today.
What is the S&P500?
The S&P500 doesweighted index of the market capitalization of the 500 largest publicly traded companies in the United States. The index includes many companies in the technology and financial sectors, as these sectors currently drive large-scale economic activity in the United States.
For decades, investors (especially institutional investors) have used the S&P 50 to measure the performance of the U.S. stock market.
Investing in the S&P 500 can include buying aETF of index fundswhich tracks the S&P 500.
Because these investments track the entire basket of companies within the S&P 500, the investor does not have to buy shares of the individual companies that make up the index or pay for an expensive mutual fund to manage the investment.
Today, the growing interest in investing solely in the S&P 500 can be attributed to the ease with which investors can purchase an index fund or ETF that provides this low-cost exposure to the S&P 500.
For exampleVanguard 500 index funds(VFINX) inVanguard S&P 500 ETF(VOO) both track the S&P 500 index. Investing in these funds offers even inexperienced investors an easy, cheap and convenient way to get into an index with high historical outperformance.
Sounds too good to be true, right? Well, that's it.
Now is the time to poke some serious holes in this strategy.
The flawed 'invest only in the S&P 500' approach.
Doubtless,the past decade has been a sensational runfor investors, with the S&P 500 posting a total return of 256%, or 13.5% annually in the 2010s, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.
This means that if you had invested $10,000 in the S&P 500 in 2010 and left it in the market, you would have almost $36,000 by the end of the decade.
For obvious reasons, this strategy seems like a no-brainer for many investors.
However, this strategy is not foolproof.
In short, investing solely in the S&P 500 is not a wise strategy for the intelligent long-term investor because it ignores some basic principles of diversification and historical unpredictability.
important,Just because the S&P 500 has delivered phenomenal returns in the past doesn't mean you should invest in this asset alone.
Even those who have already benefited from the past decade's returns can fall into the trap of creating unrealistic expectations about what the future will bring.
Here, investors must also understand the crucial importance of making long-term investment decisions with proper diversification.
Let's see why this is the case.
Minimizing Risk: The Other Side of the Equation
Before the American economist and Nobel Prize winner Harry Markowitz developedModern portfolio theoryinvestors tended to focus solely on investment returns. The goal was to buy a company with good fundamentals at a low price and watch it grow over the years.
However, Harry Markowitz noted that good investment decisions should assess returnsInrisk.
He believed that the average investor is risk aversefor the same return, an investor will choose the investment with the lowest risk.
Consequently, the investor's goal is not simply to maximize returns, but to maximize returns for a given level of risk or minimize risk for a given level of return.
Markowitz found that the risk of a portfolio (essentially your portfolio of investment assets) that is not positively correlated is lower than the risk of each individual investment in that portfolio.
For example, stocks and bonds are often negatively correlated: when the stock market rises, the bond market falls and vice versa. This means that when an investor invests in a portfolio of stocks and bonds, the risk is lower than if he chooses only stocks or only bonds. When stocks fall, bonds aren't necessarily affected, and vice versa.
According to Markowitz it isthe best way for investors to minimize risk is to have a portfolio of assets that are negatively correlated— meaning your shopping cart will contain some assets that are unaffected by others.
The advantage of this approach is that you are not exposed to all the unsystematic risks of a particular asset. Consequently, a bad turn for an asset will not cause you to lose all your money.
Without things like thatappropriatediversification, a bad turn in one stock can lead to the loss of your investment. Following modern portfolio theory creates a counterbalance that creates a portfolio designed for optimal performance.
However, most investors tend to oversimplify diversification.
Let's explain how diversification is done properly and where the S&P 500 can play its role.
Modern portfolio theory an S&P 500
Can investors who invest only in the S&P 500 benefit from this risk minimization?
Nee.
The S&P 500 only offersone level of diversification— diversification by sector.
Companies in the S&P 500 index operate in different sectors – financial, technology, medical, etc. If market factors in the financial sector lead to a downturn in that sector, growth in other sectors that are negatively correlated with the financial sector will compensate for the downturn. , protection of investors' funds.
However, investing solely in the S&P 500 does not provide other layers of diversification.
All companies are located in the United States, so a nationwide economic disaster could cause a huge financial loss. Furthermore, all companies are at the top of their life cycle (large companies), meaning there are few opportunities to achieve growth compared to small companies in the introductory phase of their business.
Likewise, the index consists only of stocks.When the stock market experiences a general downturn, there are no other asset classes (such as bonds and REITs) to offset this loss.
This is why investing solely in the S&P 500 does not help the investor minimize risk.One level of diversification cannot provide the protection you need in today's market.
What is missing from the 'invest only in the S&P 500' approachHarry Markowitzcalledbred diversification.
“When choosing a portfolio, investors should aim for broad diversification. Furthermore, they must understand that shares – and also corporate bonds – involve risks; that markets inevitably fluctuate; and that their portfolio should be such that they are prepared to brave the bad times. as well as the good times,” Markowitz said.
A major misconception is that investing in the S&P 500 index produces a diversified portfolio due to the inherent exposure to numerous companies.
Clearly this is far from reality.
While a wide choice of securities is a good starting point, it is only one of four ways to effectively diversify.
That said, investing solely in the S&P 500 is better than trying to beat the market, but it's still not good enough to achieve optimal diversification.
This strategy guarantees that the investor is exposed to an undiversified risk that has been proven to lead to significant financial losses.
[ReadThe importance of diversificationlearn more]
20 years of S&P 500 performance: an example of this
Let's go back to the year 2000.
Anyone looking to get into the S&P 500 at this point would have been happy, as the index grew nearly 18% over the past two decades, rising to over 28% in the second half of the 1990s.
But those who jumped on the bandwagon and invested all their money in the S&P may have quickly regretted it.
Why?Because there were two major bear markets in the 2000s attributed to the Internet crash of the early 2000s and the financial crisis of 2007/2008.
Performance from January 2000 through December 2009 fell short of investor expectations and even dipped negative at times. This period became known to active investors as 'the lost decade.’
The graph below shows the results over the past twenty years.
S&P 500 total return: January 00 – June 19, monthly levels
To achieve broad diversification
To achieve broad diversification, the investor must learn to diversify in several ways: asset class, market/country, sector, market capitalization and time.
- Diversification by asset class: Don't invest all your money in one asset class, such as stocks or bonds. Instead, diversify across stocks, bonds and REITs. When one asset class experiences a downturn, the other compensates, minimizing your risk.
- Diversification by market: We live in a global economy, so don't make the mistake of investing only in your own country or the US. Instead, make sure you invest in different types of stocks, bonds, and REITs in different markets. Invest in developed markets that offer consistent income and in emerging markets with high growth potential.
To illustrate this point, the table below highlights the performance of different asset classes each year from 2005 to 2018:
The most important thing here is that the best performances are different every year. If you had invested only in the S&P 500, you would have missed the winning years of the other asset classes.
(See appendix for details on each asset class.)
- Diversification by sector: When buying stocks, you should also diversify by sector. Make sure not all your shares in companies are in a single sector. Sector diversification is what the S&P 500 funds offer. Such diversification across your international market exposure is also essential.
- Diversification based on market value: Large-cap companies have limited growth potential but provide consistent income, while small-cap companies have enormous growth potential. Diversifying across large-cap, mid-cap and small-cap companies can maximize returns and minimize risk.
- Diversification over time: Make time your ally and invest as early as possible in your career so that you have more time to increase your returns. Too many people suffer from decision paralysis, where they get caught up in trying to invest at the "perfect time." Instead, they end up not investing at all and missing out on valuable time in the market.
When you invest for the first time to enjoy compound returns, you can also choose to continue growing your investments through dollar cost averaging (DCA). With this strategy, instead of waiting for the “perfect time” to replenish your investments, you can do so periodically through your robo-advisor.
By using the broad diversification techniques summarized above, you can minimize your risk and maximize your returns, come rain or shine.
Remember, your portfolio spans a world much bigger than a single country or index fund.
In this way, good diversification will also help youlimit volatility and dampen your emotions– perhaps the most dangerous threat to investors.
“You don't need a high IQ in the investing world, but you do need emotional control,” the legendary investor saidWarren Buffet.
Measuring the performance of broad diversification
There is no such thing as certainty in investing.
This maxim reinforces a timeless market lesson:Returns can fluctuate from period to period. While we should not make future investment decisions based on hindsight, we can learn some lessons from the past.
Academic research and data strongly suggest thisDiversification is the key to long-term success.
Having a broadly diversified portfolio can help smooth out swings because if one company or market does poorly in a given period, you have other areas of growth elsewhere to somewhat protect against losses. Having a good strategy based on this core principle – and sticking with it through good times and bad – can be a rewarding investment approach.
The 'lost decade' could actually have been a good decade for those who had diversified their portfolio globally to include other parts of the market such as bonds, real estate and emerging markets, rather than limiting their exposure to a single country and asset class such as shares. e.g. US stocks.
To demonstrate this powerful tool, we analyzed the performance of three different portfolios over the ten-year period from 2000 to 2009:
- A portfolio that is 100% invested in the S&P 500.
- A portfolio with an allocation of 40% to US equities, 30% to global equities and 30% to high-quality bonds. (Against risk)
- A portfolio that is globally diversified across several asset classes, including equities, bonds, real estate and commodities. (Thun against risk)
The chart above shows that investors with a well-diversified portfolio (including US stocks) outperformed both those who held all US stocks and those who held stock and bond portfolios, delivering a respectable annual return of 7% compared to the - 0.95% of the S&P over the past few years. period of time. same period.
Part of the reason the well-diversified portfolio did so well is because of its exposure to real estate (via REITs), which has a low correlation to stocks. This means that they do not move in the same direction at the same time. As a result, the investor benefits from reduced volatility and risk.
The bottom line is that the S&P 500 should be a good friend, not your only friend.
Building a diversified portfolio
Whenbuild an investment portfolio from scratchbroad diversification should be the central objective.
Instead of taking the “invest only in the S&P 500” approach, diversify your portfolio across asset class, market, sector, market cap and time.
The best way to build such a portfolio is through a robo-advisorinvesting in ETFsacross asset classes, markets, sectors and market capitalization, while diversifying over time through dollar-cost averaging and automatic rebalancing.
A typical portfolio made up of egSarwaincludes ETFs from:
- US stocks
- Developed markets
- Real estate investment funds
- New markets
- US bonds
- Global bonds
Here there is diversification by asset class: stocks, bonds and REITs. There is also diversification by market – developed and emerging.
A common ETF used to add exposure to the US stock market is the Vanguard Total Stock Market ETF (VTI), which includes large-cap, small-cap and mid-cap companies from different sectors - diversification by sector and market value.
Furthermore, Sarwa allows investors to make periodic investments with regular rebalancing, creating diversification over time.
[Wondering why ETFs are so popular and effective? Read "Why invest in ETFs: explaining the popularity of the Go-To Fund”]
Takeaways
- If you invest only in the S&P 500 (via an index fund or ETF), you'll be better off than trying to beat the market.
- However, investing only in the S&P 500 won't give you the broad diversification you need to minimize your risk and maximize your returns.
- To achieve broad diversification, you need to diversify by asset class, markets, sector, market cap and time.
- Investing in a basket of ETFs through a robo-advisor is a low-cost way to achieve broad diversification, minimize your risk exposure, and maximize your returns.
