Investing Lessons From The S&P 500

The S&P 500 may be a passive index, but it is no slouch. Just 47% of active managers have outperformed this year, according to S&P Global. Over the last 20 years, only 7% have outperformed. 93% underperformed.

Anytime I see significant outperformance, I try to learn something I can use to improve my own investing. So, what lessons can the S&P 500 index teach?

1. Think long term.

“In the end, what counts is buying a good business at a decent price, and then forgetting about it for a long, long, long time.”

— Warren Buffett

The S&P 500 committee believes "turnover in index membership should be avoided when possible.” Historically, the index has experienced 4.4% turnover, which is about 22 changes per year. While that’s not zero — the S&P 500 isn’t completely passive — it’s a lot lower than most actively managed funds. Median large cap mutual fund turnover is 55%.

One of the keys to the S&P 500’s success is that it tends to hold positions a lot longer than the typical active manager. The S&P’s 4% turnover means that half of the stocks in the index today were not in the index 20 years ago. The 55% median active turnover means half of the stocks in the index today were not there two years ago.

While researchers have not found a correlation between turnover and returns, high turnover is symptomatic of short-term thinking. Investing is a game of patience, and the investor with the longer time horizon usually wins. Few active managers end up holding stocks for twenty years or more, but the S&P 500 does.

In this sense, the S&P 500’s advantage is its structure, which predisposes it to owning stocks for decades rather than years. Similarly, housing is often the best investment people make, not because housing offers particularly high returns, but because the structure of a 30-year fixed rate mortgage pre-disposes people to own there house for several decades (h/t Morgan Housel). Plus, moving is a pain. Few hold stocks for as long because trading is easy.

Long-term ownership is important because it takes years before changes in a company’s earnings are big enough to shine through all the noise created by day-to-day market volatility.

In the short term, stock prices fluctuate significantly more than their underlying businesses. These fluctuations are random and hard to predict. In the long run, stock prices track the earnings power of their underlying businesses. So, while stock prices are relatively unpredictable in the short term, they will track earnings power, which is sometimes predictable, over the long term.

Casinos offer another example of this dichotomy between short-term uncertainty and long-term predictability. It’s a toss up as to who will win any single round of roulette. But over a long time, we know with certainty that the house will win 5.26% in American Roulette.

The table below shows just how volatile stocks are in the short term. It shows the annual price range of the ten largest stocks in the S&P 500. Year to date, the median range is a whopping 61%! Pre-pandemic the median range was still 35% per year. And these are the largest, most stable, and most closely watched businesses in the world. Most stocks are even more volatile.

Over the long run all of this volatility nets out and stock prices track underlying earnings. The table below demonstrates this with AutoZone over the last 25 years. I chose AutoZone because the company doesn’t pay dividends, which simplifies the figures.

Source: Author, Data From Value Line

AutoZone’s earnings per share (EPS) compounded at 19.80% over the last 25 years and the stock price matched that almost exactly, compounding at 19.04%. The small discrepancy is because the stock’s P/E multiple contracted from 19.7 in 1997 to 16.8 in 2022. 

P/E multiples fluctuate a lot year to year but minimally decade to decade. Zoom in on any given year and changing P/E multiples will be all you’ll notice. Zoom out over 25 years and changes in the P/E multiple are hardly noticeable — all that matters are earnings. It takes several years before changes in EPS are big enough to shine through all of the noise from volatile P/E multiples.

2. Don’t trim. Don’t double down.

Selling your winners and holding your losers is like cutting the flowers and watering the weeds.

— Peter Lynch

The S&P 500 is a market-cap weighted index. That means the stocks of bigger, more valuable companies make up a larger portion of the index than smaller companies.

There’s a subtle elegance to this. As a company succeeds and grows, it becomes more valuable and comes to occupy a larger portion of the S&P 500. Likewise, if a company stumbles and becomes less valuable, it becomes a smaller portion of the S&P 500.

The winners take care of themselves, compounding into a large allocation in the index. They’ve “earned” their prominent weight in the index. The losers also take care of themselves, compounding into trivially small portions of the index. The S&P committee never has to decide if they should trim their winners or double down on their losers. Compounding takes care of it for them.

This works because of the math of compounding. A stock can only lose 100%, but can gain a theoretically unlimited amount. A single big winner gaining hundreds of thousands of percent, like AutoZone, can make up for several losers.

Jack Bogle, the founder of Vanguard, once told WSJ reporter Jason Zweig: 

Individual investors should buy an equal amount of two or three dozen high-quality stocks and salt them away for a lifetime. He believed many would go to zero, but if only a few turned out to be big winners they would carry the whole portfolio to an outstanding return—without any burden of fees.

While few investors end up taking this coffee can approach to investing, at least one has. His name was Ronald James Read. His Wikipedia page described him as “an American philanthropist, investor, janitor, and gas station attendant.”

Read was a blue collar worker who dollar-cost averaged into dividend stocks of companies he knew, like J.M. Smuckers, Procter & Gamble, and JP Morgan. When he died in 2014 at 93 he left behind an $8 million fortune, $6 million of which went to charity. Though Read owned shares of Lehman Brothers when it went bankrupt, the loss hardly set him back. His winners more than made up for his losers.

Fidelity supposedly did a study that found its best performing clients had forgotten they had an account at Fidelity. They never traded, a true “set it and forget it” coffee-can approach.

While the Fidelity study may not be real, the concept is sound. The proof is the Voya Corporate Leaders Trust (LEXCX), which launched Nov. 18, 1935 and hasn’t traded since. Positions have only changed as the result of a bankruptcy or merger.

The fund is so old no one has a record of its performance since inception. Between 1970 and 2019 it compounded at 11.1% per year, ahead of the S&P 500’s 10.5%. It ranks 16th among all US stock funds active since 1970, which isn’t bad considering it doesn’t have a manager!

While some of the Trust’s investments have gone to zero — Pennsylvania Railroad Co. and what is now Sears Holdings Corp. — others have picked up the slack. For example, Union Carbide morphed into Linde PLC, which is up 1,200% over the past 20 years versus 230% for the S&P 500.

Today the Trust is concentrated in its biggest winners as a result of its inactivity. Nearly two-thirds of the fund is invested in four stocks: Union Pacific Corp., Berkshire Hathaway, Linde and Exxon Mobil Corp.

3. Stay fully invested. Don’t hold cash.

Cash has a high opportunity cost. Stocks routinely produce returns significantly higher than the yield on cash. The S&P 500 doesn’t hold cash, and therefore doesn’t experience any “drag” from it.

The S&P 500’s annualized return since its inception in 1928 through 2021 is 11.82% (including dividends). Its annualized return since adopting 500 stocks into the index in 1957 through Dec. 31, 2021, is 11.88% (source, data).

Many active managers try to beat the S&P 500 by timing the market: selling high, holding cash during a crash, and buying low. In theory, this sounds great. In practice, it's almost impossible to get right.

In theory, there is no difference between theory and practice — in practice, there is.

— Yogi Berra

JP Morgan once did a study that showed how quickly returns drop off if an investor misses out on the ten best days in the market. Between 1999 and 2018, missing the ten best days set an investor back over 4.5% per year.

The market's best days tend to happen just after its worst, which means investors who move to cash after the S&P 500 has fallen are most likely to miss out on the biggest rallies.

Volatility is the cost of high returns. Charlie Munger puts it bluntly:

If you’re not willing to react with equanimity to a market price decline of 50% 2-3 times a century, you are not fit to be a common shareholder and you deserve the mediocre result that you are going to get.

Rather than trying to dampen volatility by hedging, shorting, or market timing, investors should mimic the S&P 500 and stay fully invested. Grin and bear the volatility, it’s a fact of life.

William Greene recently asked Francois Rochon, one of my all-time favorite investors, about cash. Rochon said:

I remember a very brilliant investor that was a great stock picker really, but he was very prudent and he always kept 20% in cash.

So his investments that the stocks CEO owned, let’s say that 14% annually, but having the 20% in cash yielding close to nothing, reduce his overall results to 10, 11% annual. So I observed that and I said, This doesn’t make sense. He’s such a great stocker. Why not be a hundred percent invested and just live with the ups and down the stock market?

And, I learn a lot from that. So, I said to myself, my goal, my mission is to find great companies, to be an owner of great companies. It’s not to predict what the market will do. And when you have some cash in some ways you’re trying to predict the stock market.

The S&P 500’s returns demonstrate that time in the market is more important than timing the market.

4. Minimize Fees

The last point is the simplest — minimize fees. The S&P 500 index has no management fees, and the fees on ETFs that track it are minimal. Fees dig investors into a hole that must be recouped through outperformance. The larger the fee, the greater the outperformance required merely to match the index. 

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