On 16/03/1980, Joe the baker and Jack the carpenter invested in the stock market. Jack bought S&P 500 Index. Joe, on the other hand, thought that index investment is boring, and buying diversified equity instead would give better results, so he bought the stocks.
There is a prevalent notion that Index funds are static and boring. True, they don’t fall prey to sentiment movements and behavioural biases, but they are far from being static. Let’s look at S&P 500. On an average, 22 stocks in the S&P 500 are replaced every year. Stocks may be deleted due to reasons like Mergers and Acquisitions, or change of Headquarters outside of U.S, or if the stock is viewed as a “problem stock” – ie, the stock is not financially viable. Since 1980, over 320 companies were deleted from S&P as ‘problem stocks’.
So, what happens to our friend Joe the baker’s investment today, is that, at least more than half of the stocks he had bought, are not in the Index anymore. Also, a large number of his investments have either turned to losses, or performed substantially lower than the index.More than half the companies which were a part of S&P 500 in 1999, are no more included in it today. This means, that the makeup of indexes like S&P 500 are constantly evolving.
In a broader context of risk, let us look at how a single stock could greatly affect Joe’s portfolio versus S&P 500. Recently, we have seen a huge fall in the prices for many stocks. A 50% decline in price has almost become a norm in stocks that have recently plummeted and seen new lows. S&P 500 is said to give average returns of 7%per year. Supposing, each stock in Joe’s Portfolio gave a 7% annual returns for 5 years. But in the 5th year, Stock D fell by 65%. This alone, could drag his portfolio down to give a compounded annual return of ~6%, compared to the S&P’s 7% growth.
|Year||S&P 500 (@7% growth pa)||Joe’s Portfolio||A||B||C||D||E||F||G||H||I||J|
So due to Stock D, Joe’s portfolio performed below the index. This is an extreme scenario, but, it shows that in order to beat the markets, buying equities is not only riskier, but chances are, in the long run, it might hurt return on portfolios. Just one stock could drag down the entire portfolio into performing at a substantially low level of returns.
Disclaimer: This blog contains an aggregated view of analysts and opinions by the author. Do not consider this as financial advice. See http://stockal.com/legalities/