The Mighty S&P 500

Key Points

• The S&P 500 is a measurement of the stock performance of the 500 largest companies in the U.S. and is the standard investment performance indicator for the U.S. market.
• While your family/friends/talking heads might use the Dow Jones, investment professionals cite this given how robust the index is. 
• The S&P has averaged inflation adjusted ANNUAL returns of around 8% since its expansion in the1950’s.
• It is simple and cost effective for an investor (especially one with limited cash or just getting started) to purchase a passive index fund that tracks this index.

What is the S&P?

The S&P 500, or just S&P measures the stock performance for 500 of the largest publicly traded US companies across all sectors. It is widely recognized as the standard benchmark and gives a strong indication on the health of the U.S. stock market. When it comes to portfolio management, almost all investors are informed on the importance of diversification in order to mitigate risk. 

Investing in the S&P gives you full diversification across all sectors and is predominantly composed of large cap companies that many of you are already familiar with because of their products and services. 

While you continue to further educate yourself on investing, allocating a portion of your cash into the S&P is a wise first step in order to increase your personal wealth and indirectly support various companies you find interesting. 

An important note to consider though, you are not able to invest directly into the S&P 500 but you can invest in a S&P 500 index fund that mirrors the S&P.

Average Annual Return

Since the expansion of the S&P into 500 companies in 1957, the average annual return adjusted for inflation is roughly 8%. According to Barrons, only 29% of active fund managers actually outperformed their benchmark after fees in 2019. All the more reason to invest in a S&P index fund and let it compound for years.

Hedging Against Inflation

Amongst all investment products, having equity in your portfolio has historically proven to be the greatest hedge against inflation and over the long term has rewarded investors with superior returns. 

As a young investor, it is advised to have a higher percentage of your portfolio invested in equity as this will help you secure your financial future and drastically increase your overall wealth compared to the most common alternative; bonds.

How Does an Index Fund Operate?

In order to obtain exposure with the S&P 500 you actually have to buy into an index fund mirroring the S&P 500. You might be wondering how this fund actually works though. S&P 500 index funds are capitalization-weighted. This means the fund is weighted relative to each company’s market capitalization. 

Essentially, price movements on companies with higher market capitalizations will have a greater impact on the value of the index than companies with smaller market capitalizations. Think Alphabet, Microsoft, Apple, Tesla, Johnson & Johnson and J.P. Morgan Chase. This of course is subject to change.      

Compound Return

Besides actually getting your money into a S&P 500 index fund, this will be the second most important concept for you to understand as an investor. Compound return has often been referred to by notorious investors such as Warren Buffet as one of the great wonders of the investment world. 

Compound return essentially represents the cumulative percentage of return that a series of gains or losses has on the original principal invested. 

This will often be expressed as the Compound Annual Growth Rate (CAGR) and below is an example of how this will work using the S&P 500.

• The S&P 500 has an average annual return of 8%(CAGR). The truth is the S&P might return 28% one year and then -2% the following fiscal year. Since inception, the math on the average annual return has come to be about 8% adjusted for inflation.
• A young investor has chosen to make a $5,000 investment into a S&P 500 index fund.
• The average annual return remains at 8% with market volatility over five years.

Math

Year 1: $5,000 x 8%= $5,400

Year 2: $5,400 x 8%= $5,832

Year 3: $5,832 x 8%= $6,298

Year 4: $6,298 x 8%= $6,802

Year 5: $6,802 x 8%= $7,346

And So On!

Every Investor Should Think In Decades Not Years!

Conclusion

Imagine developing a budget for yourself that allows you to continuously put cash into one of these funds every month over the course of several years! 

At the end of the day, investing in the S&P 500 is a way to chill and watch your money grow and not have to sweat too much about making active investment decisions. Just have a little faith the American Economy will keep on growing. 

As an investor further educates themselves on portfolio management and becomes more comfortable with the idea of actively making investment decisions ; they could gradually begin to move forward with investing in a few different ETFs providing more concentrated exposure to a basket of stocks in a sector/ industry that is underrepresented in the S&P 500 with high upside potential.

This could be a nice transition into creating an ETF Portfolio which can be rewarding for investors who have a slightly higher risk tolerance with the hopes of superior returns over the long-run versus the S&P 500.

Check to see if your employer offers S&P 500 Index Fund options through your 401K plan. If not, online discount brokers will certainly give you access to start putting those hard earned dollars to work.

Popular S&P 500 Index Funds

1. Vanguard S&P 500 ETF (VOO)
2. SPDR S&P 500 ETF Trust (SPY)
3. iShares Core S&P 500 ETF (IVV)
4. Schwab S&P 500 Index Fund (SWPPX)