Alex Shahidi, JD, CFA®, CFP®, ChFC®, CIMA®, is a Managing Partner and co-Chief Investment Officer at Evoke Advisors.
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Investors often conclude that they would have performed better by simply investing in the S&P 500 index rather than a well-diversified portfolio. This sentiment is particularly strong when the popular market index delivers exceptional returns, such as the impressive performance since the 2009 market lows, averaging over 15% annually, based on our firm's analysis.
The dominance of great companies in the index and the narrative of continued outperformance further enhance its appeal. After all, how could investing in leading corporations not generate good returns?
Investing in leading companies can deliver poor returns over very long stretches. The issue lies in the market's relative efficiency, as it quickly incorporates all optimism into current stock prices, leaving significant room for disappointment even if the companies perform well.
An analysis of the long-term return pattern of the S&P 500 provides valuable insights into this counterintuitive dynamic.
Looking Back At Past Market Cycles
While the index has averaged around 9% per year since 1929, this average can be misleading. The 9% average encompasses distinct bull and bear market cycles that can last for one or two decades, which may prove too long even for the most patient long-term investors.
Since 1929, there have been a total of three long-term bull markets and three long-term bear markets. Bull markets accounted for 52% of the time, lasting an average of 16 years, while bear markets persisted for approximately 15 years on average. A summary of the returns is provided below:
- 1929-1949 bear market (20 years): 0% total return
- 1949-1966 bull market (17 years): 17%
- 1966-1982 bear market (16 years): 5%*
- 1982-1999 bull market (17 years): 20%
- 2000-2009 bear market (9 years): -6%
- 2009-2023 bull market (14 years): 16%
* Cash earned 7% during this bear market, outperforming the S&P 500 by 2% per year.
While the S&P 500 earned an average of 9% per year over the full 94-year period, the average return during bull markets was 18% and the average during bear markets was 0%. The underperformance of the S&P 500 during bear markets becomes even more evident when comparing returns to holding lower-risk cash. On average, the S&P 500 performed 3% worse than cash during the three bear market cycles, with annual differences ranging from 1% to 9% behind cash. In other words, investors would have been better off holding cash and assuming less risk for almost half the time since 1929.
It is challenging to identify long-term bull and bear market cycles in real-time. Investors often remain unaware of the current market state until the cycle turns and becomes more apparent over time. Moreover, bull markets do not progress linearly but contain mini-bear markets within them, which emphasizes the importance of periodically zooming out and observing the data from a broader perspective. For the purpose of this exercise, we have ignored short-term bull and bear markets and focused on longer-term stretches of good and bad returns.
A key factor contributing to the cyclicality of the S&P 500 is the self-reinforcing nature of strong recent returns, which attract more capital that propels the index further ahead. Bull markets also lead to the extrapolation of factors driving returns—such as strong earnings growth, expanding price-earnings ratios, and wider margins—into the distant future, often accompanied by a compelling narrative. This pattern has been observed in the past, such as during the 1966-1982 bear market (led by the fall of the "Nifty 50" companies) and the lost decade following the late 1990s internet bubble.
Two Key Takeaways For Investors
At present, it is unclear how much longer the current bull market may last or if it ended at the stock market's peak in January 2022. Historical turning points have often been marked by significant shifts in the economic environment. The current bull market that began in 2009 thrived due to ultra-low interest rates and massive government stimulus, both of which have reversed, with interest rates experiencing the fastest rise in history.
The sudden change in environment, coupled with typical precursors of market reversal—such as excess optimism, high margins, elevated price-earnings ratios and significant retail participation—may play a role this time.
A study of the S&P 500's cyclicality leads to two main conclusions.
First, investors should seek to build diverse portfolios that are not overly dependent on the inconsistent return stream of the S&P 500, which has a tendency to experience long periods of poor returns. (The conventional 60/40 mix does not constitute a well-balanced allocation. For an example of how to construct a more diversified portfolio see here.)
Second, based on historical returns, investors who use the S&P 500 as a benchmark for success will likely be satisfied with their portfolios only about half the time, even if they are diversified and disappointed with relative results during the other half. This is a reflection not of portfolio quality but rather of the long-term cyclicality of the market benchmark used for comparison.
Instead of comparing their performance to the S&P 500, investors that are diversified should assess their results in the context of a diverse balance of indices that reflects a more efficient long-term allocation, considering that returns may significantly deviate from the S&P 500 over shorter time frames.
The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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