Hey guys, Mike Frontera here back with another Retirement Theory video. Now, while 2020 has basically become another one of those “4-letter words” not to be repeated around young children, the stock market actually ended up with a really good year. Despite the big drop in March, the S&P 500 ended the year up 16.26%!
These last few years, every time it drops, the S&P 500 is like.
So, there is a school of thought that says to just invest in an S&P 500 fund and you will beat most of the asset managers out there. And, if you do a poking around on the Internet, you’ll find some evidence to back this up. Here’s an article from CNBC from 20191. And there’s many more like it. Here’s another one from stockanalysis.com2.
So given this kind of information that is out there, along with some great recent performance, it stands to reason that the only logical conclusion is that an S&P 500 fund should be the largest, if not the only investment in your portfolio. And this is the conclusion that a number of investors make – and it can lead to poor or even devastating results. But why?
Well, let’s start with how articles like these are often misinterpreted. If we go back to the CNBC article, the headline reads “Active fund managers trail the S&P 500 for the ninth year in a row.” Now, while there is some truth in there, it misses the bigger point entirely. It isn’t until you actually read the article that you see that you’re only talking about asset managers of US large cap funds. In other words, just the portion of the economy that is typically compared to the S&P 500. Now, for that particular segment of your portfolio, might it make sense to go into the S&P 500 fund? Of course! I use S&P 500 funds regularly as a part of my client’s portfolios. And it’s certainly true that the lower costs of index funds gives them a powerful head start over actively managed funds. So the problem isn’t that an S&P 500 fund is a poor choice as part of your portfolio. The problem is misinterpreting articles like these as the S&P 500 should BE your portfolio.
And with that said, there are two primary mistakes that investors make when thinking S&P 500 only strategy is smart.
The first is the misinterpretation of information like that which I’ve just gone through as evidence for an S&P 500-only (or mostly) strategy.
Now the second reason why an S&P 500 only strategy might, mistakenly, seem smart is something called “Recency Bias”. Recency bias is a term used in behavioral finance that basically means putting too much emphasis on events that happened most recently. And then believing that those recent events are indicative of what will happen in the future.
Let’s say you have a friend who invested in just an S&P 500 fund over the past several years. They probably did pretty well. And they likely outperformed your well-diversified portfolio too. Maybe your friend says something like “why are you wasting your time with these other investments? They’re just bringing your returns down! I’ve read that if you just hold an S&P 500 fund for a long time you’ll come out way ahead.” So maybe you do some digging online and find an article like this one3 from last year disputing the effectiveness of diversification itself. All of this misinformation out there makes the recency bias one of the toughest behavioral errors to avoid. But let’s examine a bit further to see how wrong it is.
Now, here’s one of my favorite charts, from the Callan Institute is The Periodic Table of Investment Returns. This one shows asset returns over the last 20 years, and I want to focus for now on the last 8 years. Particularly, comparing the S&P 500 to international and emerging market stocks. With the exception of 2017, the S&P 500 dominated the International and Emerging Market stock indexes. With many diversified portfolios carrying some measure of non-US stock, this has made the S&P 500 look comparatively much more attractive.
Now let’s look across the bottom of the chart to see the worst performing asset classes during this time. I want you to notice something. The first, is just how easy it has been to be in stocks in general over the past 8 years. No asset class was down by more than 15% for a full year. And in all but a couple of instances, no asset class finished the year down more than 5%. This chart doesn’t cover every area of the market, but the point is that it has been an extraordinary easy period for stock investors.
Now let’s take it back to the first 10 years of this chart. Let’s again compare the S&P 500 to the international and emerging market stock indexes. For the entire decade, there was only 1 year where the S&P 500 outperformed the other indexes. In every other year, it lagged. And check out the returns in Emerging Market Equity (which is represented by the MSCI Emerging Markets Index). Had you and your friends been comparing portfolios during this time, the S&P 500 only portfolio would have been far behind.
This period of time encompassed the so-called “lost decade” for the S&P 500. That is the ten years starting at the beginning of 2000 and finishing at the end 2009 the S&P 500 returned an annual rate of return of -0.95% per year7.
Alright, let’s pause there and think about what that means in the context of a real life example. Say you are a 40-year-old investor with plans of retiring at 60. You have all your money in an S&P 500 fund- and for this example, let’s assume you can invest with the very popular SPDR S&P 500 ETF. You enter the year 2000 right on track for your early retirement goals with a very healthy balance of $500,000. At the end of the year your retirement funds are now at $451,350. Now, you’re a disciplined investor and know that “stocks always bounce back” so you hang on. 2001 passes, which brings a further faltering economy and the worst terror attack on our nation since Pearl Harbor. Your account ends the year at $398,317. The next year brings more bad news for stocks, particularly US stocks, and a worsening recession. Over the last three years, your retirement account has gone from $500,000 down to $312,320. It should be pointed out here that your friends with diversified portfolios by and large have not dropped nearly as much, as large US stocks have been one of the worst performing areas of the market during this time. Assuming you still have the discipline to stay the course, with your early retirement on the line, you’re able to ride your portfolio back up by the end of 2007 to $565,871. You’re 47 but your retirement is back on track. Just in time for the 2008 financial crisis. You finish that year with $357,574 in your retirement funds. 2009 starts out very poorly and takes your account down even further before finishing the year strong and putting you back at $451,866. You’re now 50 years old and you have $48,134 less in your retirement than you did when you were 40. And that’s what a -0.95% per year for 10 years feels like.
Now, if you’re not phased by any of what I just went through, then you may be falling victim to the second reason investors might think it’s wise to put all their money in the S&P 500. That is, failing to understand the difference between volatility and risk. How much and how fast an investment may rise or fall over a certain period of time is volatility. But the chance that your investment results in a permanent loss of money-- that’s risk. And putting all or most of your investments in the S&P 500 entails both volatility and risk. One of the most common, yet misguided beliefs when dealing with your retirement funds is the notion that “in the long run, stocks always go up”. A Google search on long-term S&P 500 returns will generally turn up something like5, returns since 1920-something have been say, 9 or 10%. And that’s fine academic knowledge to have, but it’s meaningless for a typical investor’s much shorter real-life timeframe.
We just talked about a time where your retirement savings would’ve been down almost 10 percent after a 10 year period. Assuming you hung on and hadn’t starting withdrawing yet, you might still be talking about volatility, not risk. But how long could a downturn last before you had to bail out and take your losses? How long before even if you didn’t bail out, your goals became out of reach?
Check this out. You see this orange line here? That’s the S&P 500, from 1965 – 1989. On November 4, 1965 the index closed at 92.46. Here we are almost 17 years later, and the S&P 500 is only about 11% higher at 102.60 on August 11, 1982. Remember our 40 year old saving for a retirement at age 60? Had that been him in 1965, he’d be 57 with having barely moving the needle toward his goal. What about that blue line there? That certainly seemed to be a better move.
That’s Japan’s major stock index, the Nikkei 225. It dominated the S&P 500 during this 24-year period shown here. Year after year, decade after decade, a full generation of healthy gains, retirements funded and huge outperformance over our markets.
Can you imagine a Japanese investor, sitting in their financial advisor’s office in 1989, listening to their advisor try to convince them of the risk of putting all their money in the Nikkei 225, rather than properly diversify? “For what? To put money in the S&P 500? Are you kidding? I’m 30 years old, I can handle the ups and down of the market and I want to maximize my returns.”
The problem is, when you put all your money in any one part of the market, you’re not just talking about volatility, you’re talking about risk. Here’s where the Nikkei 225 stood on January 1, 1990, and here it is on January 1, 2021. After decades of solid returns, it spent the next 31 years losing nearly 25% of its value. No matter what point you are in your retirement savings timeline, that would be nothing short of disastrous.
And this phenomenon is not just limited to Japan. There are several indexes around the world that are still below their all-time highs and have been for years or even decades. Some significantly so. Heck we’ve had that kind of drop here in the US6. I mean sure it’s been a long time, but is it so farfetched to think it will never happen again? When you put all or most of your money into any one index, any one area of the market, with just plans of just leaving it there, it’s not the short-term volatility that’s a problem. It’s the risk that a long-term downturn exceeds your investing time horizon and causes you to permanently miss your goals.
So, do you have questions for me? Come visit me at www.retirementtheory.com or send me an email at firstname.lastname@example.org. Did you click subscribe on this video or follow me on Facebook? I think that you should. You’ll continue to see videos like these on everything retirement planning. Once again, thank you for joining me, we’ll see you next time.
- https://www.macrotrends.net/1319/dow-jones-100-year-historical-chart'>Dow Jones - DJIA - 100 Year Historical Chart