The S&P 500 index has become paradigmatic of the U.S. stock market, and several mutual funds and ETFs that passively track the index have become popular investment vehicles. These funds do not seek to outperform the index through active trading, stock picking, or market timing - but to instead rely on the inherent diversification of the broad index to generate returns. Indeed, over long time horizons, the index typically produces better returns than actively managed portfolios, especially after taking account of taxes and fees.
So, what if you had just held the S&P 500, using an index fund or some other means of accumulating the stocks held in it?
- The S&P 500 index is a broad-based measure of large corporations traded in U.S. stock markets.
- Over long periods of time, passively holding the index often produces better results that actively trading or picking single stocks.
- Depending on which time frame you use to evaluate performance, you can get different results, although on average the index always seems to do better after taxes and fees.
What If I Had Just Invested in the S&P 500?
People often use the S&P 500 as a yardstick of investing success. Active traders or stock-picking investors are often judged against this benchmark in hindsight to evaluate their savvy.
Soon after Donald Trump entered the race for the Republican nomination for president, the press zeroed in on his net worth, which he claimed to be $10 billion. Financial experts have pegged his net worth at a more modest $4 billion. One of the cornerstones of Trump's campaign has been his success as a business person and his ability to create such wealth. However, financial experts have pointed out that, if Trump had liquidated his real estate holdings, estimated to be worth $500 million, back in 1987 and invested them in the S&P 500 Index, his net worth could be as much as $13 billion.
It is just one more example of how the S&P 500 Index continues to be held up as the standard by which all investment performances are measured. Investment managers are paid a lot of money to generate returns for their portfolios that beat the S&P 500, yet, on average, less than half do so. This is the reason why an increasing number of investors are turning to index funds and exchange-traded funds (ETFs) that simply try to match the performance of this index. If Trump had done so back in 1987, he would have earned 1,339% on his money for an average annualized return of 9.7%. But hindsight is 20/20, and he could not have known that.
Using Hindsight to Predict Future Performance
Because past performance is no indication of future performance, no one can say whether the stock market will perform the same way in the next 20 years. However, you can use past performance to create some hypothetical scenarios that allow you to consider possible outcomes. To do that, look at the 20-year performance of the S&P 500 at various intervals as an indication of how it might perform under similar circumstances in the future.
One of the biggest reasons why it is impossible to predict stock market returns over a long period of time is because of the existence of black swans. Black swans are major calamitous events that can alter the course of the markets in an instant. The terrorist attacks on Sept. 11, 2001 were a black swan event that shook the economy and the markets for years. They are called black swans because they appear so rarely, but they appear often enough that they have to be accounted for when looking into the future.
You also have to consider the market cycles that can occur within a 20-year span. In the most recent 20-year span, there were three bull markets and two bear markets, but the average duration of the bull markets was 80 months, while the average duration of the bear markets was 20 months. Since the stock market’s inception, the ratio of bull market years to bear market years has been roughly 60:40. You can expect more positive years than negative years. In addition, the average total return of a bull market is 415% compared with an average total loss for bear markets of -65%.
What Would You Do With $10,000?
Choosing a Hypothetical Scenario
The most recent 20-year span, from 1996 to 2016, not only included three bull markets and two bear markets, it also experienced a couple of major black swans with the terrorist attacks in 2001 and the financial crisis in 2008. There were also a couple of outbreaks of war on top of widespread geopolitical strife, yet the S&P 500 still managed to generate a return of 8.2% with reinvested dividends. Adjusted for inflation, the return was 5.9%, which would have grown a $10,000 investment into $31,200.
Taking a different 20-year span that also included three bull markets but only one bear market, the outcome is far different. In the period from 1987 to 2006, the market suffered a steep crash in October 1987, followed by another severe crash in 2000, but it still managed to return an average of 11.3% with dividends reinvested, or an 8.5% inflation-adjusted return. Adjusting for inflation, $10,000 invested in January 1987 would have grown to $51,000.
You could repeat that exercise over and over to try to find a hypothetical scenario you expect to play out over the next 20 years, or you could simply apply the broader assumption of an average annual return since the stock market’s inception, which is 6.86% on an inflation-adjusted basis. With that, you could expect your $10,000 investment to grow to $34,000 in 20 years.
Although you cannot predict the performance of the S&P 500 Index for the next 20 years, at least you know you are in very good company. In his 2014 annual letter to shareholders, Warren Buffett included an excerpt from his will that ordered his children’s inheritance to be placed in an S&P 500 Index fund because the “long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”