Investing in the S&P 500 - YouTube

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The S&P 500 is an index of 500 US stocks

that covers roughly 80 percent

of the available US market capitalization.

It is one of the oldest

and best known stock indexes in the world.

The S&P Dow Jones Indices website

says that there are 3.4 trillion US dollars index

to the S&P 500.

That is 3.4 trillion US dollars invested in index funds

that are tracking the S&P 500 index.

That is a lot of money invested in the S&P 500.

Investing in the S&P 500 has worked out really, really well.

From 1980 through May 2019, the S&P 500 index

has on average beaten the CRSP 1-10 US Total Market Index,

while also being less volatile.

I'm Ben Felix, Portfolio Manager at PWL Capital.

In this episode of Common Sense Investing,

I'm going to tell you whether or not

investing in the S&P 500 is a good idea.

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The S&P 500 is synonymous with index investing.

There have to be a ton of people out there

who refer to themselves as index investors

while only investing in the S&P 500.

One of the most compelling arguments

for investing in the S&P 500 is its past performance.

The risk adjusted performance,

especially since the end of the financial crisis,

has been staggering.

And by staggering, I mean almost impossibly good.

Jared Kizer, the Chief Investment Officer

for Buckingham Strategic Wealth,

wrote a blog post in late 2018

where he examined the performance of the S&P 500

from March 2009 through October 2018.

He used a method called bootstrapping

to show that statistically the actual performance

of the S&P 500 over that time period

was almost too good to have been statistically possible.

The bootstrap simulation involved

taking all of the historical monthly returns

for the S&P 500 from 1926 through October 2018,

and then drawing out 116 monthly returns

to create a return series that is the same length

as the period from March 2009 through October 2018.

This can be done countless times

to simulate possible outcomes

using the actual historical data as a sample set.

In Kizer's analysis, he ran 100,000

simulated 116-month periods,

which he was then able to compare

to the actual performance of the S&P 500 index.

His findings were unbelievable.

He found that of the 100,000 bootstrap samples,

only 0.57 percent of them had better risk adjusted returns

than what the S&P 500 actually achieved

from March 2009 through October 2018.

The actual results of the index

were almost outside the range of statistical possibility.

The main takeaway from this analysis

and the point that I want to make here

is that while the S&P 500

has recently produced fantastic performance,

the probability of that performance

repeating itself in the future is extremely low.

As always, past performance

does not predict future performance,

but in this case, we have statistical evidence

to show that the likelihood

of the recent past performance

repeating itself is extremely low.

Further to this point, the S&P 500

is a lot more actively managed than most people realize.

It is not simply the 500 largest stocks in the US.

It is a committee-based index.

The stocks that go into the index

are selected by a committee of people,

not by some algorithm.

There are selection criteria,

but the ultimate decision on inclusion and exclusion

for the index is made by a group of humans.

The ultimate goal of this committee of humans

is to build an index that represents

large cap US equity markets,

but there's still a human element,

which makes repeating the exceptional past results

of the index even more unlikely.

I mentioned at the time beginning of this video

that the S&P 500 covers roughly 80 percent

of the US stock market capitalization.

That's pretty good coverage by market capitalization,

but there are closer to 3,500 stocks

that exist in the US market.

Owning 500 of the 3,500 stocks available

leaves substantial room for error

in accessing the returns of the US stock market.

Even further to that point,

there are many more thousands of stocks that exist globally.

Owning 500 of them leads to an increased chance

of missing out on the global equity premium.

Hendrik Bessimbinder at Arizona State University

just came out with a new paper

titled "Do Global Stocks Outperform US Treasury Bills?"

He and his coauthors found that from 1990 to 2018,

1.3 percent, or 811, of the 62,000 global common stocks

that were studied explained all of the wealth creation

in excess of what could have been earned in treasury bills.

1.3 percent.

Finding those stocks is like finding a needle in a haystack,

but we know that diversification is the answer

to capturing equity premiums.

We know that a small number of stocks

have driven most of the wealth creation in the US

and global markets over time.

We also know that smaller stocks,

including many of the roughly 3000 stocks

that are not in the S&P 500,

tend to beat larger stocks over the long-term.

Again, while the S&P 500 has been able to beat

the US market as a whole, and the global market,

the likelihood of that performance persisting is low,

and giving up diversification can come with a hefty price.

Past performance aside, one of the most common arguments

that I hear in favor of investing in the S&P 500

is that its constituents get roughly half

of their revenues from outside of the US.

Who needs global diversification

when you have the S&P 500?

You.

You need global diversification.

The fact that that the S&P 500 constituents

have global revenue sources does not offer you,

the investor, the benefits of global diversification.

A 2019 paper from Vanguard,

titled "Global Equity Investing,

The Benefits of Diversifying and Sizing your Allocation",

addressed this exact question.

The authors showed that while US stocks

had the lowest volatility of any country

from 1970 through September 2018,

the global market cap weighted portfolio,

including the US and all other countries,

had even lower volatility.

To prove this point, we can simply turn back the clock

and look at the past returns of US, Canadian,

and international stocks.

We know that the past decade

has favored US stocks in general,

and the S&P 500 in particular,

but if we go back to the period starting in January 1970,

ending June 2009, Canadian, US, and international stocks

all had very similar returns.

Over that period, the S&P 500 returned 9.66 percent,

while the MSCI EAFE returned 9.28 percent,

and the S&P TSX returned 9.42 percent,

all in Canadian dollars.

The US still had a small edge,

but a rebalanced portfolios,

split equally across Canadian, US,

and international stocks returned 9.84 percent,

with lower volatility than any of the individual countries.

This is, of course, the free lunch

of diversification at work.

The Vanguard paper goes on to explain

that "while the correlation of global stocks

"has increased over time, which is often used as an argument

"against global diversification,

"correlation does not tell the whole story."

Even as correlations have increased,

the dispersion of US and non-US stock returns

has remained wide.

In other words, even though markets may tend

to move more in the same direction,

the magnitude of those movements

has continued to be very different

from country to country,

meaning that there is still a substantial benefit

to owning global stocks.

A 2011 paper from AQR,

titled "International Diversification Works (Eventually)",

looked at 22 developed markets from 1950 through 2008

and examined the effects of diversification

over short and long-term periods.

Of course, anyone investing in stocks

should be most concerned about the long-term.

The authors found that while short-term market downturns

can be driven by investors changing risk preference,

or panics, as some may describe it,

longer-term results are driven more

by the economic performance of countries.

The paper concludes as follows.

"Diversification protects investors

"against the adverse effects

"of holding concentrated positions in countries

"with poor long-term economic performance.

"Let us not fail to appreciate the benefits

"of this protection."

To the point of the AQR paper,

we have to keep in mind that the world can change.

The US stock market currently makes up roughly 55 percent

of the global market capitalization,

but that has not always been the case.

In 1989, Japan made up 45 percent

of the global stock market,

while the US was sitting at only 29 percent.

From January 1989 through June 2019,

Japanese stocks have returned 0.61 percent per year

on average in Canadian dollar terms,

and Japan now makes up roughly eight percent

of the global market.

Betting on one country,

no matter how dominant its market is at the moment,

increases the likelihood of a bad outcome.

Lastly, no discussion about investing in the S&P 500

or US stocks in general is complete

without mentioning valuations.

You all know that I'm not a market timer,

but it is well-documented that current valuations

are the best predictor of future returns.

When prices are high, future returns tend to be lower.

The S&P 500 has a price earnings ratio

of 20.5 as of June 30th 2019,

while Canadian stocks are trading at 14.6,

and international developed stocks are trading at 14.7.

I'm not saying that you should bet against US stocks.

We know that valuations

can continue to rise for a long time,

but betting only on the most expensive market

does not seem sensible, either.

I've explained that the S&P 500

is probably not the most reliable approach

to capturing US stock returns, despite its past performance,

and that the S&P 500 does not offer exposure

to global stock returns,

even though its constituents have global revenue sources.

If you are currently using the S&P 500

for your US equity allocation,

it's not the end of the world.

Compared to an actively-managed fund

or a stock-picking strategy,

the S&P 500 is extremely well-diversified,

and it can be accessed for almost no cost

due to the massive scale of the ETFs tracking it.

However, the S&P 500 is not the only index

that you should own in your portfolio,

and it probably isn't even the best index to own

for your US stock exposure.

As usual, the best bet that most investors can make

is a bet on the total stock market

through a globally diversified portfolio

of total stock market index funds.

Do you invest in the S&P 500?

Tell me about it in the comments.

Thanks for watching.

My name is Ben Felix of PWL Capital,

and this is Common Sense Investing.

If you enjoyed this video, please share it with someone

who you think could benefit from the information.

And don't forget,

if you've run out of Common Sense Investing videos to watch,

you can tune into weekly episodes

of the Rational Reminder Podcast

wherever you get your podcasts.

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