Warren Buffett is Right: Investing in the S&P 500 is a Bet on America

A few weeks ago my dad called me. He was in Costco in Montana and was in awe of just how much business they do. The parking lot was full. Shoppers crowded every aisle. People lined up to wait for an open checkout lane. Pretty much every shopper was spending hundreds of dollars.

Dad called me to get my take on the spectacle of it all. He wanted to know if Costco is a good investment.

Low Cost S&P 500 Index ETF

My dad knows that my investment strategy, which I outline in detail in my book, is to invest in exactly five funds covering exactly five asset classes: Large Cap Stock, Mid Cap Stock, International Stock, High Yield Bonds, and Investment Grade Corporate Bonds.

He also knows that I use low-fee ETFs for the stock portions of my portfolio.

So, he was wondering if I was missing out on an opportunity to capitalize on Costco’s success.

I had good news for him: Costco is already in my portfolio.

Diverse Holdings

I use a low-cost S&P 500 Index ETF for the Large Cap Stock part of my portfolio. My investment mirrors the S&P 500 index, which means that I am effectively invested in the (approximately) 500 largest companies in the US. And, my investment is weighted by size. Therefore, I have more invested in the largest company, and less invested in the smallest.

Costco is currently number 53 on the list. It currently makes up about 0.5% of the S&P 500. That means that for every $1,000 I have invested in large-cap stocks, $5 is in Costco.

Sure, $5 out of every $1,000 is not a lot. But, that makes room in my portfolio for the other companies that dominate the corporate landscape in the US. As an investor in the S&P 500, I have a stake in Microsoft, Apple, Amazon, Facebook, Google, Chase, Visa, Bank of America, Johnson & Johnson, Exxon, UPS, FedEx, Verizon, McDonald’s, and over 480 other domestic giants.

Plus, the list gets updated all the time.

Tracking Success

As new companies rise to success, they enter the S&P and are automatically added to my portfolio. As ageing giants fall from grace, they are removed.

For example, Sears was the largest retailer in the US for decades. But, they were unable to keep up with the rapid changes to the retail landscape brought on by the internet. As a result, Sears was removed from the S&P 500 in 2012, which also removed them from my portfolio.

Bet on the American Economic Engine

As an investor, you get to choose where to place your bets. If you choose an individual stock, you are not just betting that their products and services will stay competitive. You are also betting that their CEO will not create a big controversy by picking a fight with regulators.

There are so many reasons that an individual stock can go up or down. It is a gamble that I am not willing to take. I would much rather bet on the house.

An investment in the S&P 500 is essentially a bet on the American economic engine. Warren Buffett put it best in a recent interview:

“You didn’t have to know accounting, you just had to believe in America. And you didn’t have to pick the right stock, you just picked America,”

Warren Buffett – Interview on CNBC 2/25/2019.

This interview was part of the media coverage of Warren Buffett’s letter to shareholders in his company’s 2018 annual report. In that letter he tells the story of how he started investing 77 years ago. He says that if a no-fee S&P 500 Index ETF had existed, it would have returned $5,288 for each dollar that had been invested.

A 1% Fee Can Cost You Half of Your Money

We have all heard the magic of compounding. It should not be terribly surprising that investing over almost 8 decades has the potential to provide massive returns.

But, it is what Warren Buffett says next that is really important.

If that hypothetical institution had paid only 1% of assets annually to various “helpers,” such as investment managers and consultants, its gain would have been cut in half

Warren Buffett, Letter to Shareholders, 2/23/2019

Actively managed mutual funds charge fees in exchange for expert management. Those fees can be lower or higher, but somewhere around 1% is pretty common.

I double-checked the math, and I am not at all surprised that Warren Buffett’s letter is correct.

If an investor receives 11.2% average annual returns for 77 years, their money will increase by a factor of 5,288 to 1. But, if they only receive 10.2%, then their increase will only be 2,465 to 1.

Assuming that actively managed funds can match their index, then a 1% management fee can cost you half your money in the long term.

And, it gets worse.

Fund Managers Underperform Their Index

It turns out that the S&P has been tracking whether fund managers have been beating their indexes. If a fund manager can beat the index by at least 1% then you would be better off having the fund manager, right?

Well, the results are overwhelmingly bad… fund managers do not consistently beat their indexes. In fact, it is very rare for a large cap fund manager to beat their index in the long run.

Large Cap Funds vs S&P 500
Large Cap Funds vs S&P 500 Source: https://us.spindices.com/spiva/#/reports

In 2018 the S&P 500 did better than 65% of actively managed large-cap funds. That means only about 1 in 3 fund managers beat the index last year.

But, that’s just the tip of the iceberg.

You should be investing for the long term. Therefore, we should look at long-term numbers. Sure, an investment manager may get beaten by the market one year, but maybe they do better over a longer time frame, right?

Wrong.

In the five years ending 12/31/2018, the S&P 500 beat 82% of large cap fund managers. So, just 1 in 5 managers beat the index.

If you stretch back 15 years, the S&P 500 beat 92% of large cap fund managers. That means only 1 in 12 fund managers has been able to beat the market for 15 years.

This may have been acceptable in years-past… before the advent of the low-fee ETF. But, computers have changed everything.

The internet killed Sears. Now, trading algorithms that can mimic indexes are killing actively managed funds.

Final Thoughts

A couple notes of caution:

First: the S&P 500 Index ETF is only one of five holdings in my portfolio. I do not want to be fully exposed to the whims of the market. Therefore, I allocate my investments into a model portfolio based on my risk tolerance. And then I rebalance. You can find my whole investment philosophy in my book.

Second: Investment decisions are incredibly complex and personal. This article is not personal financial advice, and you should always consult an investment professional before investing.

I hope this has been helpful! I welcome your comments with your thoughts and questions.

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