- The channel has grown a lot
recently, which is awesome. Thanks to everyone that has subscribed and to everyone commenting on the videos. It may be obvious to say, but the growth of the channel and all of the engagement in the comments makes the project feel
very worthwhile for me. The S&P 500 is an index of 500 US stocks that covers roughly 80 percent of the available US market capitalization. It is one of the oldest and best known stock indexes in the world. The S&P Dow Jones Indices website says that there are 3.4
trillion US dollars index to the S&P 500. That is 3.4 trillion US
dollars invested in index funds that are tracking the S&P 500 index. That is a lot of money
invested in the S&P 500. Investing in the S&P 500 has
worked out really, really well. From 1980 through May
2019, the S&P 500 index has on average beaten the CRSP
1-10 US Total Market Index, while also being less volatile. I'm Ben Felix, Portfolio
Manager at PWL Capital. In this episode of Common Sense Investing, I'm going to tell you whether or not investing in the S&P 500 is a good idea. (upbeat music) The S&P 500 is synonymous
with index investing. There have to be a ton of people out there who refer to themselves as index investors while only investing in the S&P 500. One of the most compelling arguments for investing in the S&P
500 is its past performance. The risk adjusted performance, especially since the end
of the financial crisis, has been staggering. And by staggering, I mean
almost impossibly good. Jared Kizer, the Chief Investment Officer for Buckingham Strategic Wealth, wrote a blog post in late 2018 where he examined the
performance of the S&P 500 from March 2009 through October 2018. He used a method called bootstrapping to show that statistically
the actual performance of the S&P 500 over that time period was almost too good to have
been statistically possible. The bootstrap simulation involved taking all of the
historical monthly returns for the S&P 500 from 1926
through October 2018, and then drawing out 116 monthly returns to create a return series
that is the same length as the period from March
2009 through October 2018. This can be done countless times to simulate possible outcomes using the actual historical
data as a sample set. In Kizer's analysis, he ran 100,000 simulated 116-month periods, which he was then able to compare to the actual performance
of the S&P 500 index. His findings were unbelievable. He found that of the
100,000 bootstrap samples, only 0.57 percent of them had
better risk adjusted returns than what the S&P 500 actually achieved from March 2009 through October 2018. The actual results of the index were almost outside the range
of statistical possibility. The main takeaway from this analysis and the point that I want to make here is that while the S&P 500 has recently produced
fantastic performance, the probability of that performance repeating itself in the
future is extremely low. As always, past performance does not predict future performance, but in this case, we
have statistical evidence to show that the likelihood of the recent past performance repeating itself is extremely low. Further to this point, the S&P 500 is a lot more actively managed
than most people realize. It is not simply the 500
largest stocks in the US. It is a committee-based index. The stocks that go into the index are selected by a committee of people, not by some algorithm. There are selection criteria, but the ultimate decision
on inclusion and exclusion for the index is made
by a group of humans. The ultimate goal of
this committee of humans is to build an index that represents large cap US equity markets, but there's still a human element, which makes repeating the
exceptional past results of the index even more unlikely. I mentioned at the time
beginning of this video that the S&P 500 covers roughly 80 percent of the US stock market capitalization. That's pretty good coverage
by market capitalization, but there are closer to 3,500 stocks that exist in the US market. Owning 500 of the 3,500 stocks available leaves substantial room for error in accessing the returns
of the US stock market. Even further to that point, there are many more thousands
of stocks that exist globally. Owning 500 of them leads
to an increased chance of missing out on the
global equity premium. Hendrik Bessimbinder at
Arizona State University just came out with a new paper titled "Do Global Stocks
Outperform US Treasury Bills?" He and his coauthors found
that from 1990 to 2018, 1.3 percent, or 811, of the
62,000 global common stocks that were studied explained
all of the wealth creation in excess of what could have
been earned in treasury bills. 1.3 percent. Finding those stocks is like
finding a needle in a haystack, but we know that
diversification is the answer to capturing equity premiums. We know that a small number of stocks have driven most of the
wealth creation in the US and global markets over time. We also know that smaller stocks, including many of the roughly 3000 stocks that are not in the S&P 500, tend to beat larger
stocks over the long-term. Again, while the S&P 500
has been able to beat the US market as a whole,
and the global market, the likelihood of that
performance persisting is low, and giving up diversification
can come with a hefty price. Past performance aside, one
of the most common arguments that I hear in favor of
investing in the S&P 500 is that its constituents get roughly half of their revenues from outside of the US. Who needs global diversification when you have the S&P 500? You. You need global diversification. The fact that that the
S&P 500 constituents have global revenue
sources does not offer you, the investor, the benefits
of global diversification. A 2019 paper from Vanguard, titled "Global Equity Investing, The Benefits of Diversifying
and Sizing your Allocation", addressed this exact question. The authors showed that while US stocks had the lowest volatility of any country from 1970 through September 2018, the global market cap weighted portfolio, including the US and all other countries, had even lower volatility. To prove this point, we can
simply turn back the clock and look at the past
returns of US, Canadian, and international stocks. We know that the past decade has favored US stocks in general, and the S&P 500 in particular, but if we go back to the period
starting in January 1970, ending June 2009, Canadian,
US, and international stocks all had very similar returns. Over that period, the S&P
500 returned 9.66 percent, while the MSCI EAFE returned 9.28 percent, and the S&P TSX returned 9.42 percent, all in Canadian dollars. The US still had a small edge, but a rebalanced portfolios, split equally across Canadian, US, and international stocks
returned 9.84 percent, with lower volatility than any
of the individual countries. This is, of course, the free lunch of diversification at work. The Vanguard paper goes on to explain that "while the correlation
of global stocks "has increased over time, which
is often used as an argument "against global diversification, "correlation does not
tell the whole story." Even as correlations have increased, the dispersion of US
and non-US stock returns has remained wide. In other words, even
though markets may tend to move more in the same direction, the magnitude of those movements has continued to be very different from country to country, meaning that there is
still a substantial benefit to owning global stocks. A 2011 paper from AQR, titled "International
Diversification Works (Eventually)", looked at 22 developed
markets from 1950 through 2008 and examined the effects
of diversification over short and long-term periods. Of course, anyone investing in stocks should be most concerned
about the long-term. The authors found that while
short-term market downturns can be driven by investors
changing risk preference, or panics, as some may describe it, longer-term results are driven more by the economic performance of countries. The paper concludes as follows. "Diversification protects investors "against the adverse effects "of holding concentrated
positions in countries "with poor long-term economic performance. "Let us not fail to
appreciate the benefits "of this protection." To the point of the AQR paper, we have to keep in mind
that the world can change. The US stock market currently
makes up roughly 55 percent of the global market capitalization, but that has not always been the case. In 1989, Japan made up 45 percent of the global stock market, while the US was sitting
at only 29 percent. From January 1989 through June 2019, Japanese stocks have returned
0.61 percent per year on average in Canadian dollar terms, and Japan now makes up
roughly eight percent of the global market. Betting on one country, no matter how dominant its
market is at the moment, increases the likelihood of a bad outcome. Lastly, no discussion about
investing in the S&P 500 or US stocks in general is complete without mentioning valuations. You all know that I'm not a market timer, but it is well-documented
that current valuations are the best predictor of future returns. When prices are high, future
returns tend to be lower. The S&P 500 has a price earnings ratio of 20.5 as of June 30th 2019, while Canadian stocks are trading at 14.6, and international developed
stocks are trading at 14.7. I'm not saying that you
should bet against US stocks. We know that valuations can continue to rise for a long time, but betting only on the
most expensive market does not seem sensible, either. I've explained that the S&P 500 is probably not the most reliable approach to capturing US stock returns,
despite its past performance, and that the S&P 500
does not offer exposure to global stock returns, even though its constituents
have global revenue sources. If you are currently using the S&P 500 for your US equity allocation, it's not the end of the world. Compared to an actively-managed fund or a stock-picking strategy, the S&P 500 is extremely well-diversified, and it can be accessed for almost no cost due to the massive scale
of the ETFs tracking it. However, the S&P 500 is not the only index that you should own in your portfolio, and it probably isn't
even the best index to own for your US stock exposure. As usual, the best bet that
most investors can make is a bet on the total stock market through a globally diversified portfolio of total stock market index funds. Do you invest in the S&P 500? Tell me about it in the comments. Thanks for watching. My name is Ben Felix of PWL Capital, and this is Common Sense Investing. If you enjoyed this video,
please share it with someone who you think could benefit
from the information. And don't forget, if you've run out of Common
Sense Investing videos to watch, you can tune into weekly episodes of the Rational Reminder Podcast wherever you get your podcasts. (upbeat music)
