While the S&P 500 is synonymous with index investing, its recent dominance is a historical outlier that may lead investors to overlook the essential 'free lunch' of global diversification.
The Illusion of Impossibility
The S&P 500 is the undisputed heavyweight of the investing world. With over $3.4 trillion indexed to its performance, it has become synonymous with the very idea of passive investing. For many, the index’s recent track record is the ultimate argument for its superiority. Since the end of the 2008 financial crisis, its risk-adjusted performance has been nothing short of staggering. However, a closer look at the data suggests that this era of dominance was not just good—it was almost statistically impossible.
Using a method called bootstrapping, researchers have simulated 100,000 possible market outcomes by randomly drawing from historical monthly returns dating back to 1926. When comparing the actual S&P 500 performance from 2009 to 2018 against these simulations, only 0.57% of the samples produced better risk-adjusted returns. In other words, we have lived through a period that sits at the extreme tail of probability. To build a long-term investment strategy on the assumption that this specific lightning will strike twice is to bet against overwhelming statistical odds.
The Committee and the Missing Market
Many investors mistake the S&P 500 for a purely mechanical representation of the U.S. economy. In reality, it is a committee-based index. While there are strict selection criteria, the final decision on which companies enter or exit the index is made by a group of humans, not an algorithm. This introduces a subtle element of active management into what is supposed to be a passive vehicle. Furthermore, while the index covers roughly 80% of U.S. market capitalization, it only includes 500 out of approximately 3,500 available U.S. stocks.
By ignoring the remaining 3,000 companies, investors miss out on the potential of small-cap stocks, which have historically outperformed large-cap stocks over the long term. Research by Hendrik Bessembinder highlights the danger of a narrow focus: between 1990 and 2018, a mere 1.3% of global stocks accounted for all the wealth creation in excess of Treasury bills. Diversification is the only reliable way to ensure you are holding those few 'needles' in the haystack. By limiting yourself to 500 large-cap names, you are voluntarily narrowing your search area.
The Myth of Indirect Diversification
A common refrain among S&P 500 enthusiasts is that global diversification is redundant because U.S. mega-cap companies derive nearly half their revenue from international markets. This logic is flawed. While these companies have global operations, their stock prices remain highly sensitive to U.S. market conditions, domestic currency fluctuations, and local investor sentiment. Owning a U.S. company with a factory in Germany is not the same as owning a German company subject to different economic cycles and regulatory environments.
Historical data from Vanguard confirms that while the U.S. market has been remarkably stable, a global market-cap-weighted portfolio—including both U.S. and international stocks—has consistently shown even lower volatility. Even as global markets become more correlated, the magnitude of their movements continues to vary. This dispersion is what allows a diversified portfolio to smooth out the ride. Between 1970 and 2009, a portfolio split equally between U.S., Canadian, and international stocks actually outperformed the S&P 500 with less volatility. This is the 'free lunch' of diversification that concentrated investors leave on the table.
The Price of Admission
Finally, we must address the reality of valuations. While market timing is a fool’s errand, current prices are the most reliable predictors of future returns. When price-to-earnings ratios are high, the expected return for the next decade is mathematically lower. As of mid-2019, the S&P 500 traded at a significant premium compared to Canadian and international developed markets. Betting exclusively on the most expensive market in the world is a strategy rooted in recency bias rather than forward-looking logic.
The S&P 500 is not a bad investment; it is low-cost, liquid, and vastly superior to most actively managed funds. However, it is an incomplete portfolio. The world can change rapidly—one only needs to look at Japan, which made up 45% of the global market in 1989 before entering decades of stagnation. To protect against the risk of a single country’s decline, the most sensible path remains a globally diversified portfolio of total-market index funds. The goal is not to chase the next statistical anomaly, but to capture the broad growth of the entire global economy.