The Reality of Investing in S&P 500 Index Funds

August 3, 2020

Investing

A True No-Brainer?

“Investing is simple and safe. All you need to do is put all your money into an S&P index fund.” This is a motto that is believed by many self-appointed investing gurus. These mutual funds are transparent, very low cost, and have risen tremendously historically. Furthermore, the S&P 500 has never lost money over long periods of time. But are they indeed so simple and safe?

What’s the S&P 500?

Index funds are excellent investment tools, but you can get badly hurt even while using an excellent tool. The S&P 500 index tracks the shares of America’s 500 largest public companies. Mutual funds in this category split their cash into 500 pieces, buying shares in exact proportion to the value of the companies in the index. (If the value of Apple equals 4% of the 500 companies combined, 4% of the mutual fund’s money is put into Apple stock, and so on.) Despite extensive diversification, index funds are simple to manage and usually charge annual fees that are some 90% lower than other mutual funds. Thanks to these cost savings, index funds tend to outperform most other comparable mutual funds.

S&P 500 Is Great, But…

While S&P 500 index funds have a very long record of success, choosing this investment isn’t the no-brainer some people think it is. Along with its strong growth, the S&P 500 has also been very volatile. Many investors don’t have the financial strength or nerves to deal with its extended collapses in value. Also, other index fund investments have historically done even better than S&P 500 index funds. With diversification that also includes safer options, investors can have most of the growth of index investing with less risk and angst. Let’s dig a bit deeper into the S&P 500’s potential for gains and losses.

The S&P 500 Plunges From Time to Time

While an investment in the S&P 500 gained 200% from 1999 through 2018, investors rode a real roller coaster. Stock market collapses of 5–10% are common, and just during the past two decades, the S&P 500 fell by much more: 45% in 2001 and 51% in 2008! In the crazy month. And innearly 2020 when Covid first became a reality, the index fell by 35% in just 5 weeks. It’s easy to imagine that you can stomach these ongoing financial blows, but many end up selling out during fearful times, locking in substantial losses. Historically, no one correctly predicted precisely when terrible market episodes would occur; even the greatest investors generally don’t try to “market-time.”

Recovering Can Take Years

Even people who grit their teeth and prepare to grind through a stock market crash often succumb. Depressing bear markets tend to unfold haphazardly over years, not days, weeks, or months. For example, the S&P 500’s recovery from the 2001 crash took almost six years. Then, after enjoying just a year or two of new highs, the financial crisis of 2008 dragged it back down again. It wasn’t until some four years later that shell-shocked investors in the S&P 500 finally recovered their lost ground. Even the most stalwart investor’s confidence can be shaken, especially for those who jumped in thinking they had nothing to lose.

You Can Lose Money in the Long Term, Too

True, over the very long term, the S&P 500 has always made money. But even in time frames as long as ten years, this investment has lost value (after inflation) of 10% of the past 100 cycles (1910–1919, 1911–1920, 1912–1921,… 2009-2018- etc.). No human being has an infinite time frame. The fact that your money will recover eventually is a small comfort if you don’t have funds now to pay for a wedding or generate income for retirement. Diversification helps minimize the risk, not just of a permanent loss of capital, but of experiencing a bad return just when you need your money.

Other Index Funds Performed Better

An S&P 500 fund is a great choice for many investors, but it hasn’t been the top index fund performer. While its blend of large-company stocks earned it a very solid 10.3% from 1970–2017, index funds invested in real estate, value-priced stocks, and small company stocks grew significantly more than the S&P 500. The 0.5–1% extra annual rise, compounded over that time period, led to those other funds growing 50–70% larger than the S&P 500.

Research and Diversification Required

Don’t get me wrong, I love S&P 500 index funds. But historically, a well-diversified index fund portfolio with a combination of large company stocks, small company stocks, international stocks, REITs, and bonds made more than the S&P 500 with less risk (since 1970). As with all financial matters, investors should make sure that their strategies make sense for their own circumstances and goals. Overconfidence is a terrible thing to have when your money is at risk.