Should I Just Invest in the S&P 500?

It’s basic knowledge that one of the first rules of investing is to diversify your portfolio. In the book The Elements of Investing, Burton Malkiel and Charley Ellis tell about an Enron employee who invested all of her retirement savings in the company’s 401(k). You know how this story ends: when Enron tanked, she lost everything.

Although this might be a drastic example, many investors—including some who have been investing for a while—sometimes fall into a similar trap, even though it’s often far less obvious. This trap is thinking that since the S&P 500 is an index based on the market capitalizations of 500 large U.S. companies, it’s diversified enough in and of itself. The belief is that your risk is spread across 500 companies, and that should be enough. It isn't, because true diversification means that your assets are exposed to different risks.

While the S&P 500 contains some diversification, the stocks that make up the index are still all large cap U.S. companies, exposed to many of the same risks.

It’s true that the S&P 500 has yielded some of the best returns when compared with other key market indices over the past few years. But investing is a long-term game, and the reality is the recent outperformance of the S&P 500 is actually quite unusual when compared with previous years.

The graphic below, provided by Goldman Sachs, illustrates this quite well. The performance of the S&P 500 is represented by the teal blue rectangle right in the middle of the graphic, circled in red. The colored boxes above the teal blue rectangle represent the different asset classes that had higher returns than the S&P 500 in a given year, and the boxes below it are those that had lower returns. You’ll notice that in several years, particularly the earlier years on the left, the S&P 500 had some of the lowest returns of any comparable asset class.

^{Image Source: https://www.gsam.com/content/dam/gsam/pdfs/us/en/fund-resources/investment-education/relative-asset-class-chart.pdf?sa=n&rd=n}

In 2002, the S&P was the worst-performing index on the market for other asset classes of its type, with a return of -22.1%. In 2012, it was the fifth-worst performing. In fact, the S&P didn’t start performing consistently as one of the strongest asset classes until 2013, a relatively short time ago.

The truth is that the highest performing asset classes vary widely from year to year, even if some appear to have an extended run before eventually regressing to the mean. Commodities, US Real Estate, International Real Estate, and US Small Cap assets have all claimed the top spot at one point or another in the last fifteen years.

So, if you’re questioning whether or not you should just invest in the S&P 500, the answer is a resounding no.

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