Is investing in the large-cap S&P 500 enough to ensure the kind of growth you’ll need to make your money last in retirement? On more than one occasion, influential investor Warren Buffett has suggested that investors simply buy shares in an S&P 500 index fund and let them grow.
In the Bogleheads subreddit, named after Vanguard Group founder Jack Bogle, who pioneered index funds, users call the practice of investing only in the S&P 500 “VOO and chill,” referring to the popular Vanguard S&P 500 exchange-traded fund (ticker: VOO).
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But today’s financial advisors tend to recommend broad diversification, including non-U.S. stocks, small-cap stocks and fixed-income investments in addition to large-cap domestic shares. This analysis explains the rationale behind that thinking versus the case for “VOO and chill”:
— Investing beyond the S&P 500.
— Is Buffett correct about owning only the S&P 500?
— The role of market pricing in diversification.
— How asset allocation protects investors.
— How to approach asset allocation.
Investing Beyond the S&P 500
Does diversifying beyond the S&P 500 serve investors better than a basic S&P 500 index strategy?
Investors sometimes believe they are diversifying by owning other funds, but they can end up duplicating their holdings. For example, owning an S&P 500 index fund and another domestic large-cap fund will likely mean holding many of the same securities.
“I think about this a lot, especially for younger investors,” says Kevin Thompson, president and CEO of 9i Capital Group in Fort Worth, Texas. “If you’re already in a total market ETF or the S&P 500, you essentially own the market. So why keep diversifying at the risk of just buying more of the same? A lot of these other index funds hold overlapping names.”
He adds, “You’re not adding exposure; you’re just doubling down on what you already own. That’s not diversification, that’s redundancy.”
[READ: 8 Best Warren Buffett Quotes of All Time]
Is Buffett Correct About Owning Only the S&P 500?
Peter Tanous, chairman emeritus at Lynx Investment Advisory in Washington, D.C., says Buffett is correct when it comes to young investors owning the S&P 500. “For young investors, asset allocation is a disservice. What asset allocation does is reduce volatility in a portfolio at the expense of performance,” he says.
There’s a long track record of S&P 500 performance, especially if you start counting in 1926, when the Standard Statistics Co. began compiling daily data for a 90-stock index. This was later expanded into the S&P 500. “We have about 100 years of history that says stocks are the best investment in the U.S., with a return of close to 10% a year,” Tanous says. “No other asset class can match that.”
The smart thing for young investors to do, he says, is to buy the index with regular contributions. Asset allocation will reduce volatility, but it will also reduce returns.
However, for older investors with an eye on capital preservation, allocation makes sense, Tanous says.
“When you are now rich from your 20-year-plus investments in stocks and near retirement, you will go from a growth strategy to preservation,” he says. “Then you can use asset allocation to grow more slowly and protect your principal that you may need sooner rather than later.”
The Role of Market Pricing in Diversification
True diversification involves not only spreading assets across various securities but also including different asset classes and regions that don’t move in perfect unison. This concept aligns with the broader principle that markets are efficient at pricing securities.
Many advisors advocate the notion that prices generally reflect the quality and growth potential of companies. That means it’s not enough to simply select good-performing U.S. stocks and call it diversification.
Market prices adjust for varying economic environments, whether domestic or international. By extension, the key to managing risk and maximizing returns lies in seeking sources of return that show low correlation to each other.
“It is silly to believe in American exceptionalism as relates to investment markets: Prices already adjust for these qualities,” says Rubin Miller, chief investment officer and senior financial advisor at Peltoma Capital Partners in Austin, Texas.
“It’s easy to pick good companies or good business environments, but it’s nearly impossible to pick good stocks or good countries because of this pricing mechanism,” he adds. “Same reason why it’s often easy to pick the winner of a sports match, but it’s hard to beat the bookie’s spread. Market prices are spreads.”
How Asset Allocation Protects Investors
While a broadly diversified portfolio may frequently underperform the S&P 500, investors shouldn’t overlook the advantages of managing risk through allocation, Miller says.
A basic tenet of investment returns, he says, is a preference for a smooth ride rather than being whipsawed. For example, a 20% return for two years in a row leads to a higher return than 30% in one year and 10% the following year, despite having the same arithmetic average of 20%. That’s because consistent returns compound more effectively than volatile returns with the same arithmetic average.
“Investors should prefer uncorrelated sources of return,” Miller says. “As such, all else equal, since you can’t know whether it will be U.S. stocks or ex-U.S. stocks that outperform next, but you know they don’t move perfectly in sync together, investors should prefer owning both.”
How to Approach Asset Allocation
If investors can move into fixed income, precious metals or even lean into value stocks when growth stocks are under pressure, it might soften the blow, Thompson says.
“Now, 2022 was rough. Stocks and bonds both took hits, and that crushed the traditional 60/40,” he says. “So yeah, allocation alone isn’t a shield.”
However, Thompson adds, it can pay to look beyond the U.S. “International has been outperforming the U.S. lately,” he says. “That’s diversification in action. Asset allocation doesn’t guarantee gains, but it can give you a fighting chance when things shift. Especially when the pain isn’t just local.”
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‘VOO and Chill’: Should Investors Rely on Just the S&P 500? originally appeared on usnews.com
