Methodology

Why the S&P500 is the best choice for new investors

Warren Buffett has often encouraged investment into the S&P500 because of its simplicity and superior returns compared to the majority of managed funds.
 
The stability and consistency of the S&P500 is what makes it the perfect investment for newbie investors. Since its inception in the 1920s, the S&P500 has averaged a return of 10% per year.
 
This basically means that if you invested $500 into the S&P500 around 100 years ago, it would be worth approximately $6,890,306.17 today.
 
Of course $500 was a lot of money in the 1920s and you would have to consider the impact of inflation on this figure – $500 in 1920 is roughly the equivalent of $6,477.53 in 2020.
 
Therefore, it’s clear to how powerful the S&P500 has been over the years in terms of compounding money.

What is the S&P500?

The S&P500 refers to a passively managed index fund that includes the 500 largest companies in the United States.
 
So, it includes companies like Amazon, Apple and Microsoft.
 
As you may have guessed, the companies that make up the S&P500 have changed a lot over the last 100 years. This is a good thing because the fund essentially removes companies that may no longer be up to scratch, replacing them with newer, high growth companies.
 
S&P500 funds are typically put together by banks or asset management companies. When you invest your money, it is put into a larger pot of money that includes the money of other people that have invested into the fund. This pot is used by the financial institution to buy into all 500 stocks.
 
The S&P500 funds are very popular and often receive new investments. This makes the fund very liquid, allowing you to easily sell your stake in the fund, if you wanted to.
 
The price of the fund goes up and down based on the performance of the 500 companies as a collective.
 
The S&P500 is a ‘market-capitalisation-weighted index fund’, which basically means that a slightly larger percentage of the money is invested into bigger companies, while a smaller percentage is invested into smaller companies.
 
This makes the S&P500 attractive because smaller companies are considered to be more risky and so less money is allocated into those ‘riskier’ companies, protecting your investment.

Why invest in the S&P500?

There are a number of reasons why the S&P500 is perfect for inexperienced investors. Here are 3:
 

Diversification

The S&P500 includes 500 companies which means that it is highly diversified. It includes a wide range of companies that operate in a host of different sectors.
 
This is good because your investment will be somewhat protected with hedging. This means that when one sector declines, other sectors will increase to make up (or soften) that decline.
 
According to Lawrence Fisher and James H. Lorie, who released “Some Studies of Variability of Returns on Investments In Common Stocks” in 1970, it is necessary to hold at least 30 stocks to be fully diversified.
 
As you can see, the S&P500 delivers an incredible amount of diversification.
 
It’s Passively Managed
 
One aspect of investment that often surprises people is that it is actually better to invest in funds that do not have a manager.
 
There is an abundance of research that has found this to be true.
 
For example, research by Elton, Gruber & Souza, appropriately named “Are Passive Funds Really Superior Investments? An Investor Perspective”, notes that investors can outperform actively managed funds by investing in passively managed, benchmark funds (like the S&P500).
 
There are a number of reason why this is the case, the main reasons though are that actively managed funds typically have high fees and that investment managers typically make a number of human errors that affect investment returns.
 
Low Cost
 
Simply put, a key advantage of the S&P500 is that it is typically very cheap to invest in. Most S&P500 funds offered by financial institutions are priced at a low price. For example, you might be able to find a fund that allows you to invest as little as £5 into the fund.
 
The transaction fees are also low and are typically set at around £1.50 in the UK. So, the benefit is that ordinary people can regularly invest small amounts without being beaten down by transaction fees.
 
This is attractive when you compare it to the alternative of investing in single stocks. If you were to invest into Amazon today, it would cost you around $3300 for one stock, plus $30 for the transaction.
 
Therefore, an investment in Amazon would cost you $3330 minimum. In contrast, you would easily be able to invest $50 a month into the S&P500 and it would cost you around $51.50.
 
There is some variation from one provider to the other, but the general point is that the S&P500 is very low cost.

Final Thoughts

When it comes to investing in equities, there are 3 main ways for inexperienced investors – to invest in a passive fund, a managed fund or individual stocks.
 
As I already mentioned, investing in a passive fund is better than investing in a managed fund in the majority of cases because managed funds typically offer inferior returns on investment.
 
The remaining option of investing in individual stocks is unwise for most new investors in my view. One reason is that it would be very expensive to create an effective portfolio, especially when you think that one stock in Amazon is around £3300 or that one stock in Apple is around £500.
 
If you were to invest in individual stocks, you’d probably need to invest at least £1500 per investment (on average) to make it worthwhile.
 
Therefore, to reach full diversification with 30 stocks, you’d need to invest £45,000. Not so many people have that much money to risk, especially if they were to construct a portfolio on their own – which is not advisable.
 
New investors do not have the required experience or knowledge to effectively create their own portfolio and would likely make mistakes, ultimately losing money.
 
Besides, Modern Portfolio Theory suggests that it is almost impossible to beat the market, which suggests that most investors would be best placed to invest in a passive fund like the S&P500, as it represents the American market as a whole.
Notice: The value of your investments can go down as well as up and you may get back less than you originally invested. This article does not represent personalised investment advice and past performance is not a guide to future performance, some investments need to be held for the long term. If in doubt, contact a local financial advisor for assistance.

Share this article

Share on facebook
Facebook
Share on twitter
Twitter
Share on linkedin
LinkedIn

Recommended articles...

2020 © Methodology