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Why an S&P 500 fund is a poor long-term investment

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Here’s a little advice to equity investors: The Standard & Poor’s 500 Index should not be your best friend. It’s an OK friend, but not your best buddy.

There’s been a long-standing myth that the S&P 500 SPX, +0.15%  is nearly impossible to beat. But over the past 15 years, that index wasn’t just beaten. It was left in the dust.

Fifteen years ago, at the start of 2000, the S&P 500 represented the most widely held asset class, large-cap U.S. stocks. This was no surprise, as this index had compounded at nearly 18% for the previous 20 years. And in the last half of the 1990s, it had compounded at an eye-popping 28.6%.

Any investor coming into the market 15 years ago would have been mighty tempted to jump onto this bandwagon. But many of those who did make the leap soon had good reasons to regret it.

Two major bear markets were among those reasons. But some important numbers will show others.

I recently went online and found the 15-year track records (the longest that provides) for the 10 Vanguard equity funds I recommend. All but two of those funds have 15 years of history; the exceptions are Vanguard FTSE All-World ex-US Small-Cap Index Fund VFSVX, +0.03% investing in international small-cap stocks, and Vanguard Global ex-US Real Estate Index VGXRX, -0.63% investing in international REITs.

I found one bit of good news: All eight of the funds with 15-year track records had positive returns through Dec. 31, 2014.

But Vanguard’s 500 Index Fund VFINX, +0.16% at 4.1% (annualized), was the poorest 15-year performer among the five U.S. Vanguard funds. Only the Vanguard Developed Markets Index Fund (large-cap international stocks) did worse, at 2.6%.

Here are the 15-year returns for the other six funds:

The first two of those numbers show unequivocally that value stocks and small-cap stocks were better friends to investors than the S&P 500. This is consistent with the very-long-term performance for these asset classes.

The third item on that list demonstrates that, as I have said many times in the past, putting small and value together into the small-cap value asset class can make a great combination.

That’s not all. While small-cap value stocks’ annualized returns were 2.5 times as high as the S&P 500, the real-world difference was much greater. Over the past 15 years, an investment of $10,000 would have grown to $44,713 at 10.5% (small-cap value), versus only $18,271 at 4.1% (the S&P 500).

The real difference between those numbers is even greater. With small-cap value, the annualized return was 2.5 times as high; but the actual financial gain ($34,713) was four times as high as the gain ($8,271) in the S&P 500.

The REITs fund had even higher performance, growing to $60,098 for an amazing 15-year gain (from a $10,000 investment) of $50,098. That’s six times the gain from the S&P 500.

I’m not suggesting investors abandon the S&P 500. Nor should they put everything into REITs or small-cap value stocks. I still believe strongly in diversification. This, after all, was only one 15-year period, and one in which the S&P 500 turned in its worst 15-year performance in half a century.

I’m sure that the next 15 years won’t be the same. Because future asset class performance is unpredictable, it makes sense to invest in all of them that have favorable characteristics over the very long term.

Here’s one more number to illustrate the benefits of diversification. The eight recommended Vanguard funds with 15-year track records had an average return of 6.9%.

Over 15 years, a $10,000 investment at that return would have produced a gain of $17,206 – more than twice that of the S&P alone. With that, I can rest my case for diversification.

Three lessons emerge from this little slice of history.

First, chasing recent returns is one of the biggest traps in the investment process — a trap into which so many investors fell 15 years ago, in early 2000. Surveys back then indicated many investors expected the S&P 500 to grow at 20% to 30% over the following decade.

Some people who were trying to be “realistic” figured that although they might not get 20%, at the very least they could count on getting 10%. Wrong!

Big performance is great to brag about. Big performance is great to write about in financial publications. Big performance is great to tell your friends about, even if all you can brag about is the past performance of the funds you just bought. (Did you stop to think that your purchase just produced some of the profits made by those previous investors?)

Second, as I discussed earlier, asset class diversification is a sure way to avoid being stuck holding only the worst performer. Since 1994, I have been recommending Vanguard index funds in a group of asset classes with long histories of performing at least as well as the S&P 500 — and most of them have done better.

Third, base your future growth projections on the longest track records you can find. Fifteen years of performance, which is available at Morningstar, is much more relevant than whatever has been happening in the recent past.

If you diversify properly, you won’t have to rely on any single fund or asset class to be your best buddy. Instead, you’ll have a group of funds that will all be your long-term friends.

Richard Buck contributed to this article.