You have many choices when constructing an investment portfolio, but is more really better? As it turns out, probably not. We'll briefly explain why a basic S&P 500 index fund is more than enough to be the centerpiece of your investment world, and we'll also look into some of the common criticisms of such a strategy.
What is it, anyway?
The S&P 500 is a market-cap weighted index (an index of companies arranged by the total value of their outstanding stock) that tracks the performance of 500 of the largest United States-based corporations. The S&P 500 index includes companies from all sectors, but it acts as a proxy for major corporate earnings as a whole. You can buy an S&P 500 index fund at any major online brokerage platform, and they're usually very inexpensive -- usually priced around 0.05% per year or less. Most platforms don't even charge a trading fee when the security in question is a heavily traded index fund.
Why is it enough?
"Enough" is a subjective term, but we can quickly examine why the S&P 500 is more than enough for most people:
- It's well-diversified. When you buy the S&P 500 in a single security, you receive immediate and far-reaching diversification benefits. In other words, you spread out your risk across many different industries, so you're not exposed to the company-specific risks inherent when you hold single stock positions. If you were to hold only a few single stocks, you might fail to diversify properly and leave yourself open to larger losses than you'd be willing to bear.
- It's extremely inexpensive. The beauty of an S&P 500 fund lies in its minimal price tag. Because it costs so little to buy and hold an S&P 500 fund (0.00% to 0.05% annually), you'll benefit by keeping nearly all of your investment return. If you venture into products with higher fees and fewer holdings, you potentially stand to lose more while paying for the privilege. Investing in an S&P 500 fund ensures that your costs are controlled and that your investment gains belong to you.
- It requires no ongoing management. Other than the occasional portfolio rebalance, there's no reason to touch -- or even monitor -- your S&P 500 fund as time goes on. This is the very essence of passive management: You don't need to do anything unless your overall risk profile has changed or if one part of your portfolio significantly outperforms or underperforms over a given period. The other main positive here is that you won't spend any time studying the market or fretting over technical analysis; the S&P 500 index is the ultimate set-it-and-forget-it investment.
- It offers a strong track record. Over the last 30 years, the S&P 500 has averaged about 10% in annual returns. While it's not what you would call explosive, it has been shockingly reliable over the long term. The index has effectively hedged against inflation and provided excess return at the same time, so calling it an old-fashioned method of investing isn't backed by evidence. Even better, a 10% annual compounded return can turn even very modest savings into seven-figure portfolios if you invest for long enough.
Answering the critics
One of the main criticisms of the S&P 500 fund is that it only includes large-cap companies, and it excludes other segments of the market, like mid- and small-cap companies, as well as pure international companies of any size. This is a legitimate critique, though it's important to note that mid- and small-cap companies make up only about 20% of the investable market. As the below chart illustrates, the U.S. markets have significantly outpaced international markets when it comes to price growth over the last decade.
While there's no guarantee that the U.S. market will continue to outperform international markets every year into the future, there is evidence that U.S. growth has been superior over the recent past.
Finally, holding the S&P alone is probably not a one-size-fits-all remedy for those unable or unwilling to bear stock market risk. Every portfolio comes with nuance, and each individual has different financial goals. Those at or nearing retirement probably want less equity risk than those just starting out in their careers, which means other investments with lower volatility are warranted and appropriate.
A great starter fund
If you're just beginning your investing life, look no further than the S&P 500 index. For the many reasons cited above, it can make up your entire portfolio, although people nearing retirement age will probably want to supplement it with less volatile investments. Overall, you can be confident that you're investing in a well-diversified, low-cost, and empirically studied option that delivers solid returns over the long run.