Blog & News
The Potential Hazard of Investing in the S&P 500 Index
Chris Allen, CFP
Thursday, July 30, 2020
Is it reasonable for clients to expect Total Wealth Planning to generate investment returns comparable to the S&P 500 Index? To answer this, it is important to understand the risks associated with a particular investment. Placing all of one's assets in an index such as the S&P 500, which is concentrated in large-cap US companies, is a high-risk and volatile strategy. When working with clients, we gauge each individual's capacity for accepting such high risks. We have an established process that begins with collecting responses to risk tolerance questionnaires. We also have discussions with clients about their cash flow needs and determine how much risk they have experienced before becoming a client.
I have not had a single client indicate that he or she is willing to experience declines of 50% in value. Spoiler alert: accepting this amount of volatility is absolutely unnecessary and will likely provide disastrous results. In fact, over the last 20 years, the S&P 500 index has experienced losses of at least 50% on two occasions - once during 2000-2002 then again in 2008. During these challenging periods, it was not uncommon for investors to lose patience with less diversified strategies such as the S&P 500, and abandon ship, selling in order to protect what they had left. However, this strategy often creates a cycle of market timing and, ultimately, underperformance. At Total Wealth Planning, our approach is based upon Nobel Prize-winning research, which emphasizes a diversified approach across multiple asset classes. This cutting edge academic research proved what should appear obvious, but is often forgotten, that market timing does not work! It also proved that being appropriately diversified provides the best change for success and is a superior approach to investing. This time tested strategy removes the need for market timing or even the need to select the best bond, stock or mutual fund.
In terms of investment returns, if an investor experiences a 50% loss, it requires a 100% gain in order to recover all that is lost, which can be a tall order. Returning to the examples where these declines occurred in 2000-2002 and 2008, it took a 5-6 year timeframe for the S&P 500 Index to recover what was lost. If the investor was retired, and living on the portfolio, he would have been forced into a position of selling this investment while values were down. This breaks the cardinal rule of investing, which is to avoid having to sell low, since this does not allow the opportunity for a recovery.
A traditional concept of investing is that more risk provides an opportunity for higher returns (and larger losses). When comparing our portfolios to the S&P 500 Index, our strategies typically provide the desired effect of reducing volatility (i.e. are less risky). In other words, they "win by not losing." With less risk, expectations should be for investment performance to be lower than the S&P 500. Interestingly, however, there are many times where even with less risk, the diversified portfolio generates higher rates of returns, such as from 2000-2009. This result occurs when the S&P 500 Index is not the best performing index, which is often the case. In fact, there have been a number of time periods when the Index has provided some of the worst returns, some of which have extended over a decade or longer.
A crystal ball would obviously be helpful when it
comes to investing. Why didn’t investors place all of their money in Google
before it grew, or Apple after they re-hired Steve Jobs? Even investing in the
NASDAQ, which is an index of tech stocks, would have been a great opportunity
after the declines in 2002 and 2008. However, without a crystal ball, and
without the benefit of hindsight, it is best to limit risks and avoid an
outcome where little or no investment return is generated for an extended
period of time. Very real financial challenges could result where a retiree may
need to go back to work later in life, accept a reduced standard of living, or
By comparison, the worst case scenario for a
diversified portfolio is that it underperforms a particular index, such as the
S&P 500. However, it is important to remember when this relative
underperformance occurs, while it may be frustrating for a period of time, it is
unlikely to result in jeopardizing one’s retirement goals.
In conclusion, it is essentially a trade-off: do we speculate on a particular index such as the S&P 500 and risk a tragedy? Or do we lower volatility with multiple asset classes and know that we will achieve a competitive rate of return and not jeopardize retirement goals? Clients come to us to achieve the latter!