Building BlocksS&P 500 Index
The S&P 500 is a stock market index made up of 500 large companies with publicly listed shares. The index is weighted by market capitalization, providing greater weight to the largest companies in the index. The S&P 500 is the most followed US equity index.
Beating the market, as measured by the S&P 500 Index Total Return, is hard … very hard. Take a moment to guestimate how actively managed funds perform in relation to the S&P 500 Index over a ten-year time horizon. Burton Malkiel expresses fund manager performance through anecdote:
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Over a five-year period, the S&P 500 outperforms approximately 80% of actively managed funds. Over longer periods approaching twenty years, the S&P holds an approximate 95% win rate!
Investment funds may be actively or passively managed investment vehicles. An actively managed funds has a management group that makes investment decisions regarding investments. Passively managed funds follow a market index, thus requiring no investment decisions.
Active funds have the possibility to beat the market index, making them attractive to some investors. Management may operate on a specific market strategy, sector, or investment thesis. Derivative securities may play a part in various funds, along with employment of leverage. Fund investments may be allocated in a particular ratio based on risk tolerance, holding period, age, or tax situation.
Passive funds simply mirror a market index or combination of indices. Passive investing requires leaning toward a buy-and-hold mentality. Successful investors ignore short-term volatility in favor of long-term trends as described previously.
The low costs associated with S&P 500 investments provide a significant advantage for index investors. From mutual funds to exchange traded funds (ETFs), the opportunities abound. Vanguard, Fidelity, iShares, State Street Corporation, T. Rowe Price, and Charles Schwab all offer S&P 500 index investment vehicles.
Some ETFs have an active options market at the Chicago Board Options Exchange (CBOE), along with inverse ETFs and leveraged ETFs. The Chicago Mercantile Exchange (CME) offers a futures contract for the index in three different notional sizes. There are also two index options for the S&P 500 that trade as section 1256 assets, providing beneficial tax treatment.
Overall expense ratios for S&P 500 Index vehicles start below 0.02%. Compare this to actively managed funds that often have higher taxes, additional costs to buy or sell into the investment, and expense ratios of 1%. From the starting gate, passive funds have an advantage over actively managed funds due to significantly lower costs and expenses.
There are two types of risk when investing in the stock market, systematic and unsystematic. Systematic risk, or market risk, is generally unavoidable. However, it is manageable as described previously by investing for longer time periods. As time horizon expands, market risk contracts.
Unsystematic risk is risk associated with a company, an industry, a geography, a raw material, or even a technology. Unsystematic risk is reduced by exposure to a wide range of companies and characteristics, spreading investment funds to limit exposure to any single characteristic of risk as noted above.
To diversify investments, one could purchase 1% of 100 different companies, analyzing each to avoid concentration on any single characteristic. Alternatively, investing in the S&P 500 index provides exposure to 500 different companies with a single investment. Index investing reduces unsystematic risk, improved risk/return ratios, offers exposure to a variety of characteristics, and provides a foundation for additional strategic investments going forward.
100% Win Rate
In any single year, S&P 500 performance has varied greatly, losing value in approximately 25% of one-year periods.
By considering longer time horizons, investors mitigate short-term performance risks and smooth expected returns.
When considering a twenty-year time horizon, the S&P 500 has 100% winning performance. Based on the history of the past 100 years, an investor in the S&P 500 that holds onto the investment for 20 years will make money.
source: Crestmont Research