Updated: Aug 8, 2018
The State Street SPDR S&P 500 Trust or SPY is one of the most popular ways to buy a basket of stocks representing the S&P 500 (popular by how big the fund is compared to others).
Buying an index fund is all we hear about these days, and rightly so. For many investors, buying a single fund that holds a basket of 500 of the largest and most profitable companies in the U.S. is not a bad idea.
In fact, over the last 10 years, this has been a pretty great investment strategy returning more than 10% annually (see fact sheet here). Let's drill down on each of these years.
If you read through the years, you can see there was only one down year, in 2008. $10,000 held during this 10-year period until the end of 2017 would be worth around $26,000 (before fees and expenses).
Anyone will likely agree this is a pretty nice return. Hence, the popularity of index funds. Put your retirement on auto-pilot and you'll become rich. Let's drill down a bit more.
After the recession of 2008, investors had to wait almost 2 years to break even on SPY. That's a lot of time to get your money back from being down 36%. In our view, SPY is a macro-economic investment, meaning it will go where the economy goes. In good times (like now), SPY is doing great but in bad times, SPY doesn't do so great.
Let's now compare SPY to owning a single stock, Google. This isn't a fair comparison. Owning an individual stock is much different than owning an index fund. Risker? Perhaps. Let's look at the numbers.
Google's return over the last 10 years: 13.99% annualized (as of this writing). $10,000 would have turned into around $37,000. That's $11,000 more than SPY or 42% more.
So obviously it's better to make $11,000 more from a $10,000 investment so what's the trade-off? The trade-off is volatility or something called standard deviation.
Standard deviation is a complex mathematical formula that tells us how much an investment will move from it's mean. This will tell us how high and low the roller coaster ride will get as we hold the fund or stock.
The standard deviation for SPY during the 10-year period from 2008 - 2017 (including the recession) was 15%. This means that you could expect your investment in SPY to be either up or down 15% at any given time. It will mathematically move around by that much.
For comparison, the standard deviation for GOOGL during the same 10-year period was 27%. The higher the deviation, the more terrifying (or fun) the roller coaster ride. Fortunately, for GOOGL investors, it paid off in the end with rewards far greater than SPY.
This is the trade-off investors face when deciding between index funds (and mutual funds) or individual stocks. There can be much more riches to be had in the end with individual stocks, but it will be a bumpier ride to get there.
Index funds, on the other hand will ebb and flow with the health of the economy. Don't buy into the myth that index funds always go up just because they include hundreds or even thousands of stocks. A rising tide lifts all boats, but the tide goes out eventually.
Thanks for reading our totally unfair comparison between an index fund and individual stock. Your investing style will dictate how you approach the question of what to invest in and why.
Here's the backtest data of SPY and GOOGL, including a nice chart of historical returns.