Investing in the S&P 500?  

Is the S&P 500 Worth the Risk and All You Need to Retire a Millionaire?

In the past ten years, prominent technology companies have held a significant presence in the index. The technology sector comprises more than 26% of the S&P 500, with Apple, Microsoft, and Nvidia being the top companies in terms of market capitalization. The market value of Nvidia alone is nearly equivalent to the collective value of the entire real estate sector. Amazon is ranked as the third-largest company in the index.

Shares experienced a significant decline in 2022 due to a deceleration in sales. However, they have subsequently recovered, showing an impressive increase of approximately 46% thus far this year. Like Amazon, the consumer discretionary company Tesla has also experienced a significant turnaround, positioning itself as the 10th largest stock by weight in the index.

Within the financial sector, Berkshire Hathaway holds the highest weight of 1.7%, while UnitedHealth Group emerges as the leading entity in the health care industry with a weight of 1.3%. This health conglomerate surpasses JP Morgan Chase, the largest bank in America, in terms of size and influence. The sectors with the highest shares in the S&P 500 are information technology, health care, and financials. Collectively, they encompass more than 50% of the index.

In contrast, the financial sector experienced significant disruptions, resulting in sudden collapses. The shares of Signature Bank and Silicon Valley Financial Group experienced significant declines during the first quarter, resulting in a near-total loss of value within a 30-day period, ultimately leading to the collapse of both banks. Upon analyzing the initial three months of the year, it is evident that banks or financial institutions constituted a significant portion, specifically 7 out of the 10 poorest performers on the index.

Two significant themes have been unfolding thus far this year: 

  • It is worth noting that the significant gains observed in the index are primarily attributed to the contributions of seven prominent technology companies, namely Apple, Microsoft, Nvidia, Google, Tesla, Meta, and Amazon. These companies have experienced significant returns, ranging from double to triple digits, during the current year.
  • Additionally, there have been significant outflows in the energy and healthcare sectors, amounting to $9 billion and $4 billion, respectively.

Would it be advisable to consider investing in the S&P 500?

To provide a comprehensive response, we would like to emphasize three key points.
1. The investment in the S&P 500 has yielded favorable results.

The index exhibited an average annual return of 10% during the period spanning from 1980 to 2022, excluding dividends. Certainly, certain companies may yield significantly higher returns within a given year.

Since its inception in 1957, the average annual growth rate of the entity has been approximately 10.7%. It is significant to note that any returns prior to this time were purely speculative and the result of academic postulation.

The index has exhibited a slightly superior performance over the past decade, with an average annual return of approximately 14.7%.

The S&P 500 is widely recognized as a prominent benchmark for index investing. Many individuals identify themselves as “index investors,” despite solely investing in the S&P 500. One of the most persuasive rationales for considering an investment in the S&P 500 is its historical track record.

The risk-adjusted performance, particularly following the conclusion of the financial crisis, has been remarkable.

Several years ago, a technique known as bootstrapping was employed to analyze the performance of the S&P 500 index during the period from 2009 to 2018. The statistical analysis indicates that the actual performance of the S&P 500 during that period was remarkably exceptional, to the extent that it may be considered statistically implausible.

The simulation utilized historical monthly returns for the S&P 500 spanning from 1926 to October 2018. From this dataset, a subset of 116 monthly returns was extracted to construct a return series that matches the duration between March 2009 and October 2018.

It is possible to conduct numerous iterations to simulate various outcomes by using historical data as a representative sample. The analysis conducted a total of 100,000 simulated 116-month periods, which were subsequently compared to the real-world performance of the S&P 500 index.

The findings were remarkable.

Out of the 100,000 bootstrap samples, a mere 0.57% exhibited superior risk-adjusted returns compared to the actual performance of the S&P 500 over the course of nine years.
However, it is important to note that past performance does not guarantee future results.

The term “lost decade” pertains to the specific timeframe spanning from December 31, 1999, to December 31, 2009. During this period, the S&P experienced an annual return of -0.9%. This marked the occurrence of the same event for the second consecutive decade. It is plausible that the past 13 years have represented a regression to the mean, suggesting that the upcoming decade could exhibit a greater level of average performance.

Retail investors often exhibit a tendency to purchase assets that are currently in high demand, which can be attributed to inherent human nature.
2. Many people frequently underestimate the level of active management in the S&P 500.

The selection of stocks does not solely consist of the 500 largest stocks in the United States. The index operates on a committee-based structure. Instead of relying solely on an algorithmic process, a committee of people selects the stocks for inclusion in the index.

Individuals make the final decisions regarding inclusion and exclusion after the index has undergone a selection process based on particular criteria. The objective of this committee is to construct an index that accurately reflects the performance of the large-cap US equity markets. However, it is important to acknowledge that there is a subjective component involved, which further diminishes the likelihood of replicating the exceptional historical results of the index.
3. There are a total of 3,500 stocks available in the United States market.

We would like to highlight that the S&P 500 index encompasses approximately 80% of the total market capitalization of the United States stock market.

The coverage provided is commendable; however, it is important to note that there are nearly 3,500 existing stocks.

By possessing a mere 500 out of the available 3,500, you are not fully capitalizing on the opportunities presented by the US stock market. Additionally, there is a vast selection of exceptional stocks available on a global scale.

Indeed, it is accurate to state that a limited selection of stocks has been responsible for the majority of wealth generation in both the United States and global markets throughout history.

Moreover, it has been observed that smaller stocks, which encompass a significant portion of the approximately 3000 stocks excluded from the S&P 500 index, have demonstrated a tendency to outperform larger stocks over extended periods of time.

Furthermore, although the S&P 500 has exhibited superior performance compared to the broader US and global markets in recent times, it is improbable that this level of performance will endure.
Knowledgeable investors understand that identifying successful stocks can be comparable to locating a needle within a haystack and that relinquishing diversification can result in significant consequences.

We would like to further discuss the concept of diversification.

Setting aside historical performance, a frequently cited rationale for investing in the S&P 500 is that approximately 50% of its constituent companies generate their revenues from international markets.
Does this imply that there is no necessity to pursue global diversification?

The presence of global revenue sources among the constituents of the S&P 500 does not provide investors with the advantages of global diversification.

A paper published in 2019 by Vanguard, titled “Global Equity Investing: The Benefits of Diversifying and Sizing Your Allocation,” specifically addressed the question at hand. The authors demonstrated that during the period from 1970 to 2018, US stocks exhibited the lowest level of volatility among all countries. However, the global market capitalization-weighted portfolio, which encompasses both the US and other countries, exhibited an even lower level of volatility.

A portfolio consisting of low-cost funds that are regularly rebalanced and invested in the top global companies has consistently demonstrated superior returns and lower volatility compared to investments focused solely on individual countries.

Harry Markowitz, a renowned economist and Nobel Prize winner, promoted this idea as “the free lunch of diversification.”

According to the Vanguard paper, it is observed that while markets may exhibit a tendency to move in a similar direction, the extent of these movements varies significantly across different countries. This indicates that there remains a considerable advantage to possessing global stocks.

In 2011, a research paper titled “International Diversification Works (Eventually)” published by AQR conducted an analysis on 22 developed markets spanning the years 1950 to 2008. The study aimed to investigate the impact of diversification on both short- and long-term investment horizons.

Certainly, individuals who engage in stock investments should prioritize their focus on the long-term perspective.

The researchers discovered that while brief market downturns can be attributed to investors altering their risk preferences or experiencing panic, long-term outcomes are primarily influenced by the economic performance of nations.

Diversification safeguards investors from the detrimental impacts of maintaining concentrated positions in nations characterized by subpar long-term economic performance. We should not overlook the advantages of this protection.

Certainly, it is possible for the world to undergo transformation. The United States stock market presently accounts for approximately 60% of the global market capitalization. However, this has not always been the prevailing scenario.

In 1989, Japan accounted for 45% of the global stock market, whereas the United States held a comparatively lower share of 29%. Placing a bet solely on a single country, regardless of its market dominance, heightens the probability of an unfavorable outcome. It is widely anticipated that the share of the United States will diminish in the future, while other geographic regions are projected to experience growth.
Lastly, we would like to discuss valuations.

A comprehensive discussion regarding investments in the S&P 500 or US stocks would be remiss without addressing valuations.

We do not possess the expertise of a market timer; however, it is widely acknowledged in documented research that current valuations serve as a reliable indicator of future returns.

Historically, it has been observed that elevated prices are associated with diminished future returns. As of July 31, 2023, the price-earnings ratio of the S&P 500 stood at 31.4. This figure represents a 55.7% increase compared to the market average of 20.2, which is considered the standard for the modern era. Consequently, the S&P 500 is currently positioned 1.4 standard deviations above the average. This observation implies that the current market valuation may be inflated.

What is the significance of this matter?

The price-to-earnings (P/E) ratios have an upper limit. To rationalize a price-to-earnings (P/E) ratio that consistently exceeds its historical average over extended periods, it is imperative for the US stock market to not only sustain growth but also exhibit a continuous upward trajectory in its growth rate.

We are not suggesting that it would be advisable to place bets against US stocks. It is acknowledged that valuations have the potential to experience prolonged growth; however, it is not prudent to solely rely on the costliest market for investment purposes.
To summarise 

The S&P 500 may not be considered the most dependable method for capturing US stock returns, despite its historical track record.

Additionally, it does not provide exposure to global stock returns, even though its constituents generate revenue from global sources.

If you are presently utilizing the S&P 500 as your chosen method for allocating US equity, that is acceptable.

In contrast to actively managed funds or stock-picking strategies, the S&P 500 offers a high level of diversification and is easily accessible at minimal cost, thanks to the extensive scale of the ETFs that track it.
Nevertheless, it is advisable to diversify your portfolio beyond solely investing in the S&P 500 index. In fact, the S&P 500 may not necessarily be the most optimal index for obtaining exposure to US stocks.
Typically, the most prudent choice for investors is to allocate their investments towards a globally diversified portfolio consisting of low-cost funds that encompass the world’s leading companies.

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