What are the pros and cons of investing in the S&P 500 stock index?
AI's response in regular print | Beverly Hills, CFP®, Joe O'Boyle's in italics
What are the pros and cons of investing in the S&P 500 stock index?
The S&P 500, short for the Standard & Poor's 500, is a stock market index that represents the performance of 500 large publicly traded companies listed on U.S. stock exchanges. It is one of the most widely followed equity (stock) indices and is considered a benchmark for the overall health and performance of the U.S. stock market.
The S&P 500 index includes companies from various sectors of the economy, such as technology, healthcare, finance, consumer goods, and industrials. The index is market-cap weighted, meaning that the biggest companies with the largest market capitalizations (currently Apple, Microsoft, Amazon, Nvidia, Google are the biggest) have a greater impact on its performance.
Should you invest exclusively in the S&P 500 index or should investors diversify across other asset classes such as the small cap and mid cap stock indexes as well as international stock and emerging market stock indexes?
Investing exclusively in the S&P 500 stock index, compared to diversifying across multiple indexes such as small and mid-cap, international, and emerging market indexes, has its own set of pros and cons. Let's explore them:
Pros of Investing in the S&P 500 Index Exclusively:
Broad Market Exposure: The S&P 500 Index represents a broad cross-section of the U.S. stock market, consisting of 500 large-cap companies across various sectors. By investing exclusively in the index, you gain exposure to the overall performance of the U.S. economy.
Simplicity and Convenience: Investing in a single index fund that tracks the S&P 500 offers simplicity and convenience. This keeps investment costs low and allows for a straightforward investment strategy without the need to manage multiple positions or make frequent portfolio adjustments.
Historical Performance: Over the long term, the S&P 500 has historically delivered solid returns. It has been a consistent performer and has outperformed many actively managed funds and other investment options.
If you invested $1,000 in the S&P 500 stock index at the beginning of 1926, you would have over $11 million at the end of 2022, assuming you reinvested all dividends. This is a return on investment of 10.08% per year and illustrates the incredibly powerful combination of time and compound returns when investing in a broadly diversified mix of stocks over the long-term.
The S&P index returns start in 1926 when the index was first composed of 90 companies. The name of the index at that time was the Composite Index or S&P 90. In 1957, the index expanded to include 500 companies and was called the S&P 500. Today, the S&P 500 is one of the most popular U.S. stock market benchmarks because it tracks the performance of about 500 of the largest publicly listed U.S. companies which represent 80% of available U.S. market capitalization.
Pros of Diversifying Across Multiple Stock Indexes:
Risk Mitigation: Diversification across different asset classes, market segments, and geographic regions can help reduce portfolio risk. By including small and mid-cap indexes, international indexes, and emerging market indexes, you can potentially offset the volatility and concentration risk associated with a single index.
Opportunity for Higher Returns: Diversification allows you to tap into the growth potential of different market segments and regions. Small and mid-cap stocks have historically offered higher growth potential compared to large-cap stocks, while international and emerging markets provide exposure to economies and sectors that may outperform the U.S. market.
Exposure to Different Market Cycles: Different market segments and regions may go through different market cycles, providing opportunities for returns even when one segment may be underperforming. By diversifying, you can potentially benefit from different areas of the market that are in favor at different times.
Cons of Investing in the S&P 500 Index Exclusively:
Concentration Risk: Investing solely in the S&P 500 Index means being heavily exposed to large-cap U.S. stocks. If a particular sector or group of companies within the index underperforms, it can have a significant impact on your portfolio.
Because it’s a market cap weighted index, there are times when the S&P 500 index is top heavy with a large portion of the index invested in just a handful of stocks. For example, investors may be surprised to learn that, currently, 5 mega cap technology stocks make up roughly 25% of the weighting in the S&P 500 index (with the other 75% of the index being invested across the remaining 495 stocks).
There have been prolonged periods of time where the S&P 500 index has experienced flat and sometimes even negative returns. For example, during the period from 2000 to 2009, the S&P 500 experienced a negative return and is known as “the lost decade”. The good news for long-term investors, is that after a period of poor performance (such as the “lost decade”), the S&P 500 index has experienced extended periods of terrific performance.Limited Geographic Exposure: By focusing exclusively on the S&P 500, you miss out on potential opportunities in international markets and emerging economies, which may offer higher growth prospects.
For example, there have been periods where the international stock index - MSCI EAFE index - has meaningfully outperformed the S&P 500 stock index:
—International stocks outperformed the S&P 500 by 81% from Jan 1970 - Oct 1978
—International stocks outperformed the S&P 500 by 68% from Mar 1985 - May 1995
—International stocks outperformed the S&P 500 by 54% from Feb 2002 - July 2011
Cons of Diversifying Across Multiple Indexes:
Increased Complexity: Diversifying across multiple indexes requires managing and rebalancing multiple positions, which can add complexity to your investment strategy. It may require more time, research, and monitoring compared to a single index approach.
Currency and Political Risks: Investing internationally exposes you to currency fluctuations and political risks specific to each country. These factors can impact returns and add another layer of complexity and risk to your portfolio.
Performance Variability: While diversification aims to reduce risk, it can also lead to periods of underperformance. There will be times when certain segments or regions outperform the S&P 500, and vice versa. It's important to have a long-term perspective and not react impulsively to short-term fluctuations.
In summary, investing exclusively in the S&P 500 Index offers simplicity and broad exposure to the U.S. market, but it may come with concentration risk and may somewhat limit your global exposure and corresponding opportunities for growth. Diversifying across multiple indexes provides the opportunity for risk reduction, exposure to different market segments, and potential higher returns, but it requires more effort and entails additional risks associated with international investments. The optimal approach depends on your risk tolerance, investment goals, time horizon, and preference for simplicity versus diversification. Consulting with a financial advisor can help you make an informed decision based on your specific circumstances.
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Joe O'Boyle is the founder and principal of O'Boyle Wealth Management, a full service financial planning and investment management firm, located in Beverly Hills, California. Joe O’Boyle was named to InvestmentNews 40 under 40 class of 2016, and has a catalog of financial planning and investing articles on Money.com & U.S. News. Disclosure information.