Friday, July 23, 2004

Why I buy the S&P 500

When it comes to finances, it is always good to have a benchmark. For instance, for emergency savings, there is no reason to settle for less than the interest rate on short-term Treasury bills unless you need the convenience of a checking account. The benchmark for longer-term investing is the S&P 500 index.

When I first looked at the mutual funds availible to me in my 401(k), only one fund seemed like it might surpass the S&P 500 benchmark -- Fidelity Magellan. But Peter Lynch was no longer its manager. With huge amounts of money invested, it began to resemble the S&P 500, but with more expenses. I decided to watch Magellan's progress and invest in the index fund. As it turns out, Magellan has "returned" -3.17% annually to the index's -2.04% over the last five years.

There are three elements in the success and failure of mutual funds to beat their benchmark: 1) investment skill, 2) expenses, and 3) investment domain. The first and second points are obvious and, in theory, counter-balance. An index fund requires little to no skill, but minimum expenses. A managed fund has more expenses, but rewards investors with more gains from investment skill. In practice, many managed funds fail to beat their benchmark even without accounting for expenses.

The third point, investment domain, is a description of what sort of securities a fund is allowed to invest in. Over a long period of time, stocks of small U.S. companies have returned more than government bonds, for instance. So all other factors being equal, a small cap fund will do better over many years than a government bond fund.

An S&P 500 index fund has low expenses, will match its benchmark and invests in the 500 largest public companies in the United States. It may not be exciting, but it has been the bulk of my retirement savings for the last five years.

1 comment:

Anonymous said...

Jon,

Just surfing the web and I saw this finances section. If you want to read a good book on the subject there is a book called "The intelligent investor" I can't remeber who wrote it but it was written in the 1930's i beleave and it was written by a guy who lost it all in the market crash. The book has been updated for recent times. One of his basic premises is to buy both stocks and bonds. When you read the book he explains the purpose but basically bonds are great for a bear market and stocks of course are good for a bull market. The ratio of stocks to bonds is about 80% stocks (or mutual funds) and 20% bonds. The idea is that of course you dollar cost average and don't sell even when the market looks bad but you adjust the ratio of stocks to bonds. Anyway i had a long conversation about the book crosing the pond on the way back from germany awhile back and have been meaning to read the book. It is not light reading but has pearls of wisdom from an old timer which is something I have read in "The purpose driven life" is a good thing to do, listen to old timers advice.

Also Another sage peice of financial advice In have aquired is thinking about the actual cost of a coke from a coke machine (apply to all bought things in life). The cost of the average coke is $0.50. This does not figure in other costs such asthe taxes you payed to the government so add about maybe 10 cents to that price. Next figure in the time value of that coke if you invested it in the market, perhaps over a year it will gain 2 cents. Now consider that you buy on average about 3 cokes at about $0.50 each during a week. That total cost to your wallet is about $100 dollars a year that you could put straight into an IRA. Amazing how much money we americans can waste!

Anyway i'm enjoying your blog.

-Dave