MARK HULBERT
Hidden lessons in the S&P 500's 50th birthday
A closer look at the ultimate evidence in support of buy-and-hold investingBy Mark Hulbert, MarketWatch
Last Update: 12:20 AM ET Mar 3, 2007
ANNANDALE, Va. (MarketWatch) -- In the midst of the market's turmoil this past week, you may have missed it but the Standard & Poor's 500 Index is marking its 50th birthday this weekend.
The S&P 500 (SPX : 1,391.97, -3.44, -0.2% ) made its debut on March 4, 1957, and in the decades that followed it has become one of the most-watched stock market indices. Although more investors on Main Street pay attention to the Dow Jones Industrial Average ($INDU : 12,192.45, -15.14, -0.1% ) , more people on Wall Street probably pay attention to the S&P 500 than to any other index.
Standard & Poor's, the creator and keeper of the index, estimates that $1.26 trillion is directly invested in mutual funds and other investment vehicles that are indexed to the S&P 500, and that an additional $4.45 trillion is invested in funds that tie their performances to this benchmark.
That's a lot of money, especially given that the total value of all publicly traded stocks in this country is around $14 trillion.
When the S&P 500 arrived on the scene on that March day in 1957, it closed at 44.06 -- around 3% of its closing value on Friday.
If you add in the dividends that the 500 stocks in the index earned along the way, this increase works out to an annualized return of 10.83%. (The dividend-adjusted S&P 500 returns are courtesy of Prof. Jeremy Siegel of the Wharton School of the University of Pennsylvania, who is a renowned scholar of long-range investment cycles.)
If 10.83% annualized doesn't look all that good to you, consider this: $1,000 invested in the S&P 500 on March 4, 1957, would be worth around $170,000 today.
VolatilityPerhaps the most obvious lesson to draw from this 50-year history is the need to take a long-term perspective on investing. This is especially important to keep in mind during weeks like the one we just experienced, when extraordinary short-term volatility can divert our attention away from, and even whip-saw us out of, our long-term strategies.
But there are other, even more profound, lessons to be learned from the S&P 500's long-term history that are less obvious unless you dig a lot deeper.
Take, for instance, what buy-and-hold investing really entails. Most investors would think that investing in an S&P 500 index fund would fully qualify as buying and holding.
If a company is overvalued at the time it gets added to the index,
its net effect from that point forward will be to detract from the index's performance.
But that, strictly speaking, is not completely accurate. Of the 500 stocks that were in the S&P 500 on March 4, 1957, only 86 remain part of the index today. The remaining 414 companies were either taken over, went bankrupt, or were otherwise removed from the index along the way. In fact, the number of additional companies that at some point were added to the index over the last five decades numbers close to 1,000.
To be sure, the turnover implied by these additions and removals isn't huge. Yet it's also not the same as purely buying and holding.
To appreciate the virtues of purely buying and holding, you have to consider a portfolio that did exactly that -- buying the 500 companies in the S&P 500 in 1957 and making no other changes over the next 50 years. That means you would have continued to hold each of those stocks, even if Standard & Poor's took them out of the index. And if any of those original 500 stocks was taken over by another company, you would have continued to hold whatever compensation you received from the acquiring company.
And, finally, it means that you wouldn't have bought any of the additional companies that Standard & Poor's added along the way.
OutperformingBelieve it or not, according to Siegel, this pure buy-and-hold portfolio would have performed even better over the last 50 years than the actual S&P 500 index did, and not by just a little bit, either.
Indeed, it would have boasted an 11.71% annualized return over the last fifty years, or 88 basis points per year more than the S&P 500 index actually returned.
To put that into perspective, $1,000 invested in this pure buy-and-hold portfolio 50 years ago would be worth some $254,000 today, vs. the $170,000 that would have been realized by investing in the actual S&P 500.
Not a bad return on doing nothing.
This is an incredible finding, if you stop to think about it. What it means is that the net effect of all changes to the S&P 500 index over the last 50 years has been to markedly reduce the index's returns.
This seems counterintuitive, to say the least. In 1957 there were few technology companies among the 500 companies that made up the S&P 500; nor, for that matter, were there many health-care or financial companies. Today, of course, these three sectors represent nearly half the index's components.
And yet, even though the list of the original 500 stocks had few companies in these sectors, they still outperformed the actual S&P 500 that added them along the way.
Why would this be? In an interview, Siegel said that a big reason is the process by which a company ends up getting added to the S&P 500. In almost every case, a company that gets added is at least a mid-cap company, if not a large-cap. That in turn implies that the stock of the company getting added will already have enjoyed a big run-up in the years prior to its getting added to the S&P 500.
That also means, according to Siegel, that sometimes the company will be overvalued when it gets added to the index.
The implication, of course, is clear: If a company is overvalued at the time it gets added to the index, its net effect from that point forward will be to detract from the index's performance.
TelecomA telling example comes from a book Siegel wrote a couple of years ago, "The Future for Investors," on how telecom stocks got added to the S&P 500 during the Internet boom.
Siegel writes that virtually no new telecom stocks were added to the S&P 500 during its first 40 years in existence. "But in the late 1990s, new firms, such as WorldCom, Global Crossing, and Qwest Communications, entered the index with great expectations for growth and much fanfare, only to collapse afterwards," Siegel noted. "In June 1999 WorldCom constituted over 16% of the telecom sector's market value, but the firm subsequently lost 97.9% of its value by the time it was deleted from the index in May 2002. Global Crossing fell more than 98% before it was deleted from the index in October 2001, and Qwest lost over 90% of its value since it was admitted in July 2000."
Another telling illustration of the virtues of buying and holding comes from Norman Fosback, author of "Stock Market Logic." Fosback was head of the Institute for Econometric Research, and editor of several investment newsletters, the best known of which was Market Logic. He currently edits a newer service called Fosback's Fund Forecaster.
Fosback's illustration deals with the first major S&P 500 index fund, which was created by Wells Fargo in the early 1970s. As that bank was preparing to buy each of the 500 stocks in the index, the institution's investment committee balked at 19 stocks that were, in their view, such obvious financial basket cases that it would be foolish to buy them -- perhaps even a violation of their fiduciary responsibility to do so. As a result, the bank's first S&P 500 index fund actually owned 481 stocks, not all 500.
This decision on Wells Fargo's part had little real-world impact on the index fund, since the stocks that they kept out of the fund had very little market cap and thus very little weight in the S&P 500's overall performance. But Fosback says that, as a challenge to Wells Fargo, he decided at the time to create a non-index-fund out of the dozen or so stocks that were kept out of the index.
How did this non-index fund portfolio perform? It "consistently and decisively beat the S&P 500 over the following ten years," Fosback said.
The point of Fosback's anecdote is not to make fun of the Wells Fargo investment committee. My bet is that, if you and I had been on that committee in the early 1970s, we would have agreed with them that the stocks they eliminated should indeed be avoided at all costs.
The correct lesson to draw, I think, is how incredibly difficult it is to pick stocks that will outperform or underperform the market, even when the evidence seems overwhelming that they will do so.
And that, I submit, is the most important lesson to draw on the occasion of the 50th birthday of the S&P 500.
