I Love the S&P 500

S&P 500

 

I’ll never forget the time I approached my fiancée’s financial advisor to understand why his returns on her portfolio were so poor. He was a family friend and had been managing her family’s money for a long time, but I just couldn’t understand such paltry results year after year.  So, I had a meeting with him.  At that time, I asked him what he benchmarked against.  This is when the tap dancing began.  He used phrases that he thought I wouldn’t understand like “asset allocation” and “diversification of the portfolio through alternative measures”.  

 

That’s when my probing questions began.  I wanted to know if he really understood the models and their indicators, so I asked him why he bought a European Gold Fund and American Gold Fund, and if he would explain the difference between the two funds.  He quickly confessed that he didn’t know the makeup of the mutual funds and that he relied solely on a model from his investment firm to run the portfolio.  Needless to say, if you’re paying someone to invest your money, and they can’t explain what they are doing, it’s time to move on.

 

A Little History

Have you ever wondered why people (like me) benchmark against the Standard & Poor’s 500?  The S&P 500 is currently comprised of 505 of the largest companies to represent all industries in the United States.  The reason it encompasses 505 companies and not 500, per its name, is because it includes two class shares for five companies, including Comcast, Discovery Communications, Google, News Corp. and Twenty-First Century Fox as of July 1, 2016.  

 

One of the most remarkable things about the S&P 500 is that since 1928, it has returned close to 8%.  This is a very good return in comparison to bonds, which have averaged around 5% and in comparison to real estate, which has returned just 0.2% after adjusted for inflation.  Many investors turn to mutual funds and hedge funds in hopes of beating the S&P 500 but spend little time thinking about the management fees incurred which often times can exceed 1%.  

 

Additionally, Jack Bogle was the first person to set up a market index fund in 1975, the Vanguard 500 Index Fund, based on the research that mutual funds underperform stocks.  Instead of trying to beat the market, he set the goal to cut fees and passively mimic the market.

 

Mutual Funds

Let’s say that you invest in a mutual fund for $10,000.  Before the mutual fund even invests your money, they essentially charge you $100 to manage your money.  Now, the mutual fund company really has $9,900 to manage for you.  In order for the mutual fund to beat the S&P 500 annual return of 8%, the mutual fund would actually need to make greater than 9.1% just to breakeven with the S&P 500.  If the mutual fund continues to charge you 1% each year, over 30 years, your portfolio will be reduced by a minimum of 30%, which means the difference between a $300,000 portfolio and a $200,000 portfolio.  As you can see, fees matter.

 

There is a very well-known financial author and speaker, Dave Ramsey, who I agree with 90% of the time. But, when it comes to investments and more specifically mutual funds, I believe he is dead wrong.  He says two specific things in his courses that really irk me.  Firstly, he assures his audience that fees don’t matter.  Clearly, we can acknowledge that fees do matter because the mutual fund, by default, has a greater hurdle in order to beat the S&P 500, and overall one’s portfolio can be reduced by these fees if it does not exceed the returns of the S&P 500.  And, Dave counters this point by saying that on average, the mutual funds that he invests in return 12%.  

 

Let me explain to you the difference between average and annual returns because there is a HUGE difference.  Let’s say you invest $100 into Apple stock.  If in the first year, Apple goes up by 50%, great, now you have $150.  However, the next year, if Apple drops by 50%, sadly, you are left with $75.  Based on an annual rate of return, you would have a 25% loss.  But if you follow Dave Ramsey’s reasoning, the average rate of return would be 0%, since Apple went up 50% the first year and down 50% the second year.  This Mark Twain quote couldn’t be more fitting: “There are three kinds of lies: lies, damned lies, and statistics.”  With that said, be very careful when someone spits rate of return figures at you; they may be sorely inaccurate.

 

Here’s another little secret that the financial industry won’t tell you; most mutual funds fail.  The data shows that on average, 75% of actively managed mutual funds underperform the S&P 500 every year.  For context, in 2014, 86% of actively managed funds failed to beat the market, and in 2015, 66% of the actively managed funds failed to beat the market.  So, what does the industry do when a mutual fund underperforms for a couple of years?  They quietly close it down as if it never existed.  That way they can remain marketable to individual investors in order to convince you to purchase one of their other mutual funds that seem to be beating the market.  

 

In 2015, Chuck Jaffe reported that over the last eight years, only four actively managed mutual funds have beaten the S&P 500.  This bears repeating; only four actively mutual funds beat the S&P 500 over eight years.  According to the most recent study there are over 9,000 mutual funds so the chances are 0.04% that you would have picked the correct mutual fund to beat the S&P 500 or 99.6% you would have chosen the wrong mutual fund. This is truly remarkable, so as you see, the odds are against an active mutual fund beating the S&P 500.

 

Buying the S&P 500

Hopefully I have presented a good argument against selecting mutual funds and have convinced you to buy the S&P 500.    

 

Here are the three biggest ETFs that mirror the S&P 500:

  1. SPY (SPDR S&P 500 ETF)
  2. IVV (iShares Core S&P 500)
  3. VOO (Vanguard S&P 500).  

Since each of these funds mirror the S&P 500, you may wonder which one to choose.  Here are two ways to decide the right ETF for you:

  1. If you hold a Fidelity or Vanguard account, you can normally buy these funds (IVV for Fidelity and VOO for Vanguard) without paying a brokerage commission.  
  1. If you don’t have a brokerage account with either one of these broker services, you can look at the expense fees for each ETF.  According to Morningstar, SPY fees are currently 0.09%, IVV fees are currently 0.07% and VOO fees are currently 0.05%.  

 

I have opened up a Vanguard account in order to invest in VOO based on the low expense fees and the commission-free trades.

 

I’d love to hear from you.  Please share with me why you think I’m right or wrong with the strategy above.  

Mustard Seed Money

Welcome to the website. A mustard seed is a very small seed but astonishingly grows very large over time. My hope is that through your financial journey that your small investment in time, money and faith will grow beyond anything that you could ever imagine.

15 Comments

  1. I would have been super annoyed by that adviser, did you move the funds over ? Do you invest in the total stock market or just the S&P 500 index fund ?

    • David – Thanks for the comment. We moved the funds about three months later and fortunately have done much better managing the fund ourselves.

      The account is mainly in the S&P 500 index with smaller positions allocated towards the Nasdaq 100 and Berkshire Hathaway.

      I plan to write a future post about why I sometimes deviate from my S&P 500 index advice.

      Have you had any experiences with financial advisors?

  2. I have made some of the worst investing fails, from USAA and American funds I had some pretty bad experiences (http://davidsdollars.com/investing-fail-usaa/)

    I have called around to some companies like Edward jones but they steer me to some other big companies that have pretty high fees so I don’t really bother anymore. I mainly just stick with Vanguard and Fidelity.

  3. Well done!

    The so-called financial advisor is a bunch of sales people. Anyway, their time is over with robo-advisor

    One more thing, the S&P 500 is going for a correction sooner than later, it’s a good time to look for alternatives.

    Keep up the good work.

  4. You are absolutely right and I am glad you are spreading the truth. I feel like I am telling people to invest in the S&P 500 or DJIA every time I talk to them about investing. The sad thing is, most of the responses I get are, “what is that?” So it seems like the majority of people are being held back from making the best decision possible with their money (and an easy one!) just through sheer ignorance. Rather than doing the simplest, cheapest, and best investment, the S&P 500 index etf or fund, they get suckered into foolish complexity by a sales person posing as an investment advisor. When I was younger I wanted to be a stock broker because I was interested in the stock market. I quickly realized through some internships that it was a sales job and if I wanted to study and learn I should be an equity analyst. Thankfully I was able to do that in one of my jobs for a few years and I liked it a lot more!

    I like your site!

    • Oh man I wanted to be a stock broker as well but learned the say lesson that you did. I have a friend that became one and I asked him how they measure success. He said that it’s whoever has the most assets. I asked him who had the best returns for the year. He said we don’t measure that. How crazy is that?

  5. Great argument for passive index funds! Appreciated all the evidence you used to back up your point.

    The only point I’d add is that while sp500 based funds are great for wealth building, other low cost funds may be better for more specific goals. For example, a dividend appreciation fund or Reit would be good if you’re investing for income, bond fund for shorter term savings, emerging markets for diversification etc.
    But yes, index funds are absolutely the way to go!

  6. Hmmm you caught him good there :)!
    It’s a shame that people involved in the industry who follow that mindset are tarnishing it for the rest of the mostly decent advisors out there

    Agreed on your approach as well

    Cool blog you’ve got here, keen on reading more!

  7. Hi MSM,
    A great story and I’m glad you were able to correct your finance’s investing.
    Any reason why you like the S&P 500 over a total stock market fund though? The S&P tracks fairly well to the overall market, but it doesn’t have small cap stocks which add more diversification.
    Best wishes,
    -DL
    Dividend Life recently posted…Does valuation matter for an income investor?My Profile

    • Hi Dividend – I have the asset allocation balanced in my 401k. I probably should have explained that. That probably makes for a good post. Thanks for stopping by and asking 🙂

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