The S&P 500’s recent performance has made investing look easy. Why bother with more diversified and complicated strategies?

The S&P 500 has been on something of a tear.

Total returns have been about 24% over the last 12 months with cumulative returns of 235% over the last 10 years.

Impressive, to say the least.

This is the kind of investment performance that can make some investors wonder whether Warren Buffet was right when he suggested that for most individual investors, investing in the S&P 500 ought to be their only investment strategy.

Whether it’s the right strategy for an individual investor is something they would need to decide. This note is no way meant to challenge Warren Buffet’s investment perspective! Or, for that matter, to suggest an alternative strategy for individual investors.

But, recency bias can be powerful, so with the S&P 500 up as much as it has been over the last few years this note is intended to remind investors why this kind of concentrated investment strategy would require real patience and conviction at times. The S&P 500 has regularly underperformed more diversified investment strategies, as well as other broad public equity indexes, by amounts, and for periods of time, that would not have been easy for most investors to ignore.

How the S&P 500 Has Performed Over Time Compared to a 60 / 40

Over the long term, the S&P 500 has had really strong results: about 12% annualized since 1974. $1,000 invested in the S&P 500 fifty years ago would have grown to $257,000 today.

Those results are stronger than more diversified strategies, like a 60% S&P 500 / 40% 10-Year US Treasury portfolio. It would have generated annualized returns of about 10% over that same 50-year timeframe. $1,000 invested in that 60 / 40 portfolio would have grown to $112,000—about half what the S&P 500 investor would have achieved.

However, a lot can get lost in long-term averages, specifically the episodic and very large drawdowns the S&P 500 has experienced, and its underperformance relative to a 60 / 40 portfolio over multiple time periods. Time periods that were long enough for many investors to find hard to just ignore.

As can be seen in the Chart 1 below, an investor who had 100% of their portfolio invested in the S&P 500 in September 2000 would have lost 45% over the following 2 years, about twice that of an investor in a 60 / 40 portfolio, who would have lost 22%. And then it would have taken the 100% S&P 500 investor more than 6 years to recover their losses and almost 20 years to catch up to the 60 / 40 investor!

Chart 1 also shows the other periods of time where a 100% S&P 500 investor would have suffered large and worse drawdowns than a 60 / 40 portfolio: in the late 1970s (37 months of worse performance); in the early 1980s (73 months of worse performance); and in the late 1980s (92 months of worse performance).

These were intense losses followed by prolonged periods of relative underperformance. These painful experiences do not show up in long term averages and they are easy to forget when the S&P 500 has been on a tear, as it has been recently.

Some individual investors may very well be able to handle those kinds of drawdowns and underperformance. But many individual investors live with near-term realities that constrain their ability to ignore short- and medium-term results, like the potential need for unplanned withdrawals and the psychological stamina required to stick with concentrated investment strategies. Investors in a 100% S&P 500 need to be confident they can in fact handle the challenges they are likely to face—and not lose conviction and sell during a drawdown. This would crystalize loses and undermine the investment strategy.

Many large institutional investors also live with constraints, like filing requirements for pension funds, career risks for fund managers, and the practical realities of trying to maintain client and board confidence, that would make sticking with a concentrated investment strategy challenging during periods of prolonged underperformance. Instead, they are much more likely to pursue a diversified investment strategy with less downside. And, even then, they are still likely to have to contend with the challenge of explaining their more diversified strategies, when less complicated strategies perform really well—like they have in recent years! No investment strategy works all the time, but for most institutional investors, the risks associated with a concentrated strategy would be too much.

None of this is meant to sound like a blazing insight! The benefits of diversification are well known, but concrete examples are useful to remind oneself of why, when the S&P 500 is up by about 100% over the past 5 years, and 60 / 40 is up by just 50%.

How the S&P 500 Has Performed Relative to Other Major US and Global Indices

The S&P 500 is often used for passive public equity strategies because it has had strong long-term returns, and it is easy to replicate (it tracks large, listed companies and it is market capitalization weighted which requires less trading than equal weighted indices).

However, as can be seen in Table 1 below, the Nasdaq, Wilshire 5000 and the DJI have all generated annualized returns since 1979 that are amazingly close to the returns of the S&P 500. And, over rolling 5-year periods, the S&P 500 has rarely been the best performing index.

Investors in a 100% S&P 500 portfolio will need to be prepared for the very real possibility that they will face long periods of time when other broad US public equity indices will perform significantly better. 

It is also important to remember that while the US public equity markets have been a good investment over the last 50 years and currently represent approximately 60% of global listed equities, non-US public equity markets have generated better returns over multi-year periods of time. For example, between 1982 and 1988 (using end-of-year values), the annualized returns of the MSCI global index (ex-US) were 31% compared to the S&P 500, which generated returns of 16%. The global index again outperformed the S&P 500 between 2001 and 2009. Over this period, annualized returns of the global index were 7% compared to 2% for the S&P 500.

The Bottom Line

There is no denying that the S&P 500 has generated extraordinarily strong returns over the last few years as well as strong returns over the very long term.

But recency bias is powerful and can be risky.

It is important to remember what investing in a 100% S&P 500 portfolio is likely to look and feel like at times: it is likely to involve long periods of underperformance relative to conventional alternatives, like a 60 / 40 portfolio and other broad US or global indices.

Individual investors need to be sure they can handle those periods of underperformance, without abandoning their strategy at the worst time and crystalizing losses. Individual investors who do pursue a more concentrated investment strategy are likely going to need real patience and conviction at times.

For many institutional investors, this kind of concentrated investment strategy could result in periods of underperformance that would be too much to bear. Instead, they are likelier to construct portfolios that are diversified across asset classes as well as global and US equities. And even then, ironically, they are still likely to find themselves explaining their diversified strategy when simpler strategies are generating very high returns—like recently!