Recently, I’ve read countless articles about how investing in index funds is one of the most sensible ways to invest your money. Investors must be listening, since the top three largest mutual funds attempt to replicate the stocks and returns of the S&P 500 Index. And who could blame them? For the last 10 years (ending 7/31/2021) the S&P 500 has generated an average annual return of 15.35% and has only had one negative year (2018 had a return of -4.38%). In addition, these mutual funds have expense ratios hovering around zero. What’s not to love?
Because of all these reasons, we are a huge fan of index funds. The idea of broad diversification, low costs, and buy and hold ticks off many of the boxes we think are important when it comes to investing.
But there are some concerns we have for investors who have gone “all-in” on the S&P 500 that should be thoughtfully considered; and we sum this list of concerns up by saying: know what you own. Don’t be afraid to pop the hood and figure out what is inside your S&P 500 fund that has generated such great returns. The old disclaimer, “past returns are not a guarantee of future results”, holds just as much weight when investing in S&P 500 funds as it does with all other funds. Consider the following:
Single Stock Risk
No matter what stock you invest in, when you concentrate your money in one or a small handful of stocks, there is significant risk. Just ask the owners of Enron, Lehman Brothers, General Electric or Worldcom. If you own the S&P 500 Index, you may think you have broad diversification across 500 stocks, and you would be half-right. What you may not know is that the largest stocks in the S&P 500 make up a significant weight of the overall index. The top 6 companies (of the 500 total) represent 24% of the index. That means if you put $1 million into the S&P 500, $240,000 would be invested in 6 stocks. Your returns will be heavily dependent on the performance of these 6 companies.
You may say, “Who cares? I still am getting diversification across those stocks and the rest of the S&P 500 will help balance things out.” That may seem true at first blush, but when you dig into the index, you’ll find a different story. The total exposure of the index to Information Technology (ex: Microsoft, Apple), Communication Services (ex: Google, Facebook) and Consumer Discretionary (ex: Amazon, Tesla) is over 50%. When such a large portion of your money is allocated to the high-tech space, there is risk. And what you thought was extremely diversified may have significant exposure to just one sector.
When you buy a stock one of the factors that should be considered is how expensive it is relative to a metric like earnings or book value. Historically, companies that are inexpensive relative to those metrics have higher expected returns. When we look at the concentration in both the technology sector and the top names in the S& 500 index, we see how expensive this index has gotten. Since 1935, the average price-to-earnings (PE) ratio of the S&P 500 has been 15.5. That means on average, we need to pay $15.50 for a stock that will generate $1 of earnings. When we look at the current PE ratio, it has spiked all the way up to 24. Perhaps more concerning is the concentration I mentioned in the first two paragraphs. Every one of these stocks have PE ratios over the long-term average. Price matters. What you pay for a stock will be a major contributor to the long-term return you experience.
Here is what the top 6 holdings look like in terms of PE ratios:
- Apple: 26.46
- Microsoft: 33.56
- Amazon: 58.48
- Facebook: 28.90
- Google: 30.49
- NVIDIA: 54.95
Just over 20 years ago we experienced a market not too dissimilar to what we are seeing now. High valuations in the technology sector, concentration in the S&P 500 index in just a few stocks, and exuberance about the future potential of the technology sector. Many of you probably remember what came next- a stock market crash that erased 50% of the value of the index over a three-year period. For the next 10 years, the S&P 500 went through what some analysts dubbed, “The Lost Decade”.* Interestingly, this was not at all a lost decade for other asset classes:
|Asset Class||Index||Cumulative Return|
|US Large Cap Stocks||S&P 500||-9.10%|
|US Value Stocks||Russell 3000 Value||32.75%|
|US Small Cap Stocks||Russell 2000||41.26%|
|Foreign Developed Stocks||MSCI World ex USA||17.47%|
|Emerging Market Stocks||MSCI Emerging Markets||154.28%|
|Real Estate||DJ Global REIT||162.42%|
|Energy Pipelines/Transport||Alerian MLP||473.91%|
*Returns from 1/1/2000 to 12/31/2009- “The Lost Decade”
It is important for investors to take note. We are not predicting any sort of market crash, but for the last 10 years the S&P 500 was one of the best options for investors. We don’t know what is going to come next, but it is imprudent to disregard the elevated risks we are seeing by concentrating a portfolio into one asset class like large US stocks. Those who don’t know their history are doomed to repeat it.
So now what?
If the S&P 500 has risks associated with it, what should investors do? First, there are over 12,000 stocks in the investable universe, so we have never believed that the 500 largest US stocks should make up for all or most of an investor’s portfolio. Broad, global diversification is the key to smooth out returns over the long-term. No one wants to go through a 10 year stretch of negative returns and one of the best ways to minimize that risk is diversification.
We believe investors should own a broad mix of all stocks: large and small companies; growth and value companies; US and International companies. And even stocks that don’t belong in any of those camps like Real Estate Investment Trusts and Energy Infrastructure companies. Every investor is different so determining how much of each to own (along with the percentage of the total portfolio that should be in safe assets like bonds) is one of the most important decisions you will make. Working with an advisor that can allocate your assets based on your overall objectives, cash flow, tax situation and retirement plan is a great place to start.
As it relates to the S&P 500, we recommend taking a hard look at your allocation if you have all or a large portion of your investments in a fund that tracks this index. Concentration and valuation risk points towards having a healthy weighting in stocks that have cheaper valuations- namely international, emerging markets, US small cap and value stocks. Their returns may not be stellar the last 10 years, but their long-term historical average and relative valuation should warrant consideration.
As always, if you have questions related to any of your investments, please don’t hesitate to reach out to us at Greenspring.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.