Welcome to episode 73 of the One for the Money podcast. I am so very grateful you have taken the time to listen. In this episode, I will share why investors should look beyond investing in just the S&P500.

In the tips, tricks, and strategies portion, I will share a tip regarding mutual fund and ETF management fees (also known as expense ratios).

In this episode...

Cost Considerations [2:39]
Growth Limitations [4:55]
Diversification and International Exposure [9:49]

Years ago, I spoke with a gentleman who had his own company. He learned I was a wealth manager and expressed his frustration that the advisor who was managing his company’s 401k plan had made some poor predictions about the economy and consequently grossly underperformed the stock market. He then asked me an interesting question: why not just invest everything in the S&P500 and be done with it?

This gentleman isn’t the only one with that same question and some, in fact, follow this philosophy by investing only in the S&P500 believing it is a wise investment strategy. Here are several significant reasons why investors should look beyond investing in just the S&P500.

But first, it must be noted that the possibility of this discussion is entirely thanks to the pioneering work of Jack Bogle of Vanguard. He deserves so much credit for what he accomplished in ensuring people could invest in passive index-based funds. Before him, you couldn’t inexpensively invest in the 500 stocks of the S&P500. There wasn’t an option, but because of the index funds he created, he made it possible to do so incredibly inexpensively. It will cost you just $3 a year for every $10,000 to invest in the 500 companies of the S&P500 index. That is remarkable.

Now many think one can solely invest in the S&P500 and be done with it. But historical analysis has shown that there are compelling reasons to invest in more than just the stocks listed in the S&P500.

Indexing vs Indexing plus

The first reason is that investing in an index can actually be more expensive. Many think it is a really inexpensive way to invest and from a cost of management perspective, it is. But you have to consider more factors than just the cost of management. I’ll explain. The S&P500 is an Index. An index is just a publicly available list of stocks. It’s sort of like an investment recipe. But unlike grandma’s tried and true chocolate chip cookie recipe, the “ingredients” of the S&P500 change from time to time. In a dynamic capitalist-based economy, companies grow bigger and others grow smaller. This requires changes to be made to the list of stocks, or in other words, changes to the investment recipe. And whenever changes are made to the index, it’s announced so everyone knows the stocks that will be added, the stocks that will be removed, and the date when it will happen. Consequently, everyone knows what all of the indexes are going to buy and sell. As one can imagine the costs can increase as a result. There are passive investment strategies, like factor investing which I featured in episode 68, where they employ more flexibility in what they buy and sell. Buying stocks whenever one else is, is a lot like buying roses on Valentine's Day. It’s a more expensive way to buy both roses as well as stocks.

We have a very recent example. On September 6 of this year, 2024, it was announced that the company Palantir would be added to the S&P500 Index starting on Sept. 23, 2024, and you will never guess what happened, The stock rose 13% in the next trading session. By the time all of the indexes add this stock to their investment list, the price of the stock will likely be much higher. That’s an expensive way to buy stocks.

Another reason why the index can be more expensive is because they only buy and sell a few times a year when the changes are announced. The S&P 500 rebalances on the third Friday of March, June, September, and December. This process involves changing the weightings of companies in the index and sometimes adding or removing companies. That can lead to buying stocks at higher prices. But with other types of passive investing, it allows managers to buy and sell every day the market is open and take advantage of more favorable prices.

Large cap vs small cap

The second reason why the S&P500 index isn’t necessarily the best option is because it only represents the largest companies in the United States, namely those with a market capitalization of at least $10 billion. You might think that’s a good thing but it’s wise to remember that every company started out as a small one. Amazon and Apple and Microsoft are what’s called MegaCap companies because they have a valuation of over $200 billion. In fact, Apple and Microsoft have a larger value than the GDPs of Canada, Russia, or Spain. But at one time Amazon, Apple, and Microsoft were operated out of a garage or small office and would then grow to become small publicly traded companies and later mid-sized companies, then large companies, and now mega-sized companies. By investing only in the S&P500 you missed out on the most significant aspects of their growth. Take Shake Shack vs McDonalds. When it comes to investing, you want the company you are investing in to grow rapidly and smaller companies will grow faster. Shake Shack from a percentage perspective will be adding a lot more restaurants than McDonalds will. That doesn’t mean we don’t invest in McDonalds and larger companies. In fact a good amount of my and my clients’ investments are invested in large companies, however, we also have a good amount invested in smaller companies because that’s where the most explosive growth can occur. But if people only invest in the S&P500 you are only investing in the American companies after they got really large and you will miss out on buying the Apples, Teslas, Nvidia, and Microsofts when they were smaller. Again, using Palintar as an example. In the two years prior to joining the S&P500, the stock soared 350%. Those who invested in mid/small caps could have enjoyed that growth but those who solely invested in the S&P500 missed out on all of it.

To further my point as to why investing in small company stocks is important. For the period between 1926–2016, the compound annual growth rate of return was 11.4% for the Small Company Index and it was 10.0% for the Large Company Index. That may not seem like a significant difference but over that 90-year period, $1 invested in small caps would have grown to over $20,000 where as $1 invested in Large cap would be just over $6k. And since 1927 through December 2023 small stocks outperformed large stocks and 68% of the time after 10 years.

Another reason to invest beyond the S&P500 is because of valuations.

Some stocks are more expensive than others. Confusingly, this has nothing to do with the price of the stock but rather the price of the stock relative to the earnings of the company. This is known as the P/E ratio. Companies for which you pay a higher price for earnings are called a growth stock whereas companies for which you pay a lower price for earnings are called a value stock. The difference can be significant. Historically, value stocks have outperformed growth stocks in the US, often by a striking amount. Data covering nearly a century backs up the notion that value stocks—those with lower relative prices—have higher expected returns.

The S&P500 at times has become overvalued and some of that overvaluation can be concentrated on growth stocks. For example, in September 2024, the top 10 companies of the S&P 500 are 36% of the index. That’s right 2% of the companies make up 36% of the value.

And as of July 31, 2024, the top 10 companies had a price-to-earnings ratio of 31.4 times earnings whereas the bottom 100 had a ratio half that, 15.3%. No one can predict where the market goes from here but historically growth stocks at these high valuations tend to come back to earth. In fact value stocks have outperformed growth stocks by 4.4% annually in the US since 1927. Since 1926 through December 2023 value stocks were higher than growth stocks 70% of the time after 5 years and 78% after 10 years.

Another reason to look beyond the S&P500 is it doesn’t focus on a company’s profitability. That may seem like a captain obvious type comment but factoring in companies with higher profitability can make a significant difference for investors. Since 1963 through December 2023 high profitability companies were higher than lower profitability companies, 67% of the time after one year, 82% of the time after 5 years, and 92% of the time after 10 years. The S&P500 doesn’t always reflect the most profitable companies.

Domestic vs International

A final reason to invest beyond the S&P500 is because you miss out on investing in great international companies. The S&P500 is composed of solely large American Companies, but there are a lot of great companies beyond our nation’s borders. Some of those companies reside in more developed countries such as Great Britain, France, Taiwan, or Japan while other up-and-coming countries, defined as emerging market economies have great companies as well.

An additional reason to consider international stocks is sometimes they zig while the S&P500 zags. In fact there was a period of time where an investment in the S&P500 was down 9% after ten years. so if you had invested $10,000 in the S&P500, ten years later your investment would have been worth just shy of $9100 dollars. That’s a poor return after 10 years time. That period of time was from January 2000 to December 2009. January 2000 was the height of th...