“Why should I own anything other than the S&P 500?”
This is a common question investors are asking today.
Why are they asking it?
Because over the last decade, the S&P 500 has outpaced every other major asset class by a wide margin, gaining 11.2% per year versus 7.1% for U.S. small cap stocks, 6.3% for U.S. real estate, 3.6% for international stocks, 1.6% for emerging market stocks and 0.9% for U.S. bonds.1
And within the S&P 500, the outperformance of the four largest companies has been even more dramatic, with annualized returns ranging from 17.0% (Google) to 27.6% (Microsoft).
Given this backdrop, it’s not surprising to hear investors question the benefits of diversification, asking why they should own anything other than just the S&P 500 (aka “the winners”).
This is a valid question to which there is one good answer: because no one knows with any certainty who “the winners” of the future will be.
Because we can’t accurately predict the future, prudence requires building a diversified portfolio that can withstand multiple possible outcomes.
And one of those possible outcomes is that the future will look different than the recent past, with large-cap U.S. stocks underperforming everything else.
Has that ever happened before?
Indeed, it has. There’s a cycle to everything in markets; nothing outperforms forever.
At the end of 2009, many were bemoaning the “lost decade” in which the S&P 500 declined 0.9% per year. It may seem hard to believe, but back then investors were questioning whether large-cap U.S. stocks would ever regain their footing.
Fast forward to today, and not only did the largest U.S. stocks come back but they’ve been so dominant it’s hard to imagine a scenario in which they’ll ever underperform again. But that’s always the case after a huge run — and the longer it goes on, the more we believe in its permanence.
In markets, there’s no finer example of this than Japan.
At the end of 1989, the Nikkei 225 Index had wildly outperformed the rest of the world, culminating in one of the biggest asset bubbles in history. Japanese investors were very confident that Japan was the only place to be and that adding anything else to a portfolio was a foolish endeavor.
What would those same investors say today, 34 years later, with the Nikkei still below its 1989 peak?
They’d probably say that the best time to diversify is when it’s the last thing you would ever want to do. Because that’s when you need it the most.