How Compounding the S&P 500 Could Skyrocket Your Portfolio
The Standard & Poor’s 500 Index (S&P 500) is an American index made up of 500 large market capitalization stocks from different industries that serve as the benchmark for the U.S. stock market. The index is considered the best replication of the performance of the largest collection of the most reputable, powerful, and wealthy companies in America. The reason for its market representation is due to it holding the greatest portion of the overall market value.
Some of the notable companies included are:
• Apple Inc.
• Microsoft Corporation
• Exxon Mobil Corporation
• Amazon.com Inc.
• Johnson & Johnson
• Berkshire Hathaway Inc. Class B
• General Electric Company
• JPMorgan Chase & Co.
• Alphabet Inc.
• Procter & Gamble Company
• AT&T Inc.
• Chevron Corporation
• Coca-Cola Company
• Wells Fargo & Company
Since Standard & Poor’s is a corporation itself, it has a group of analysts and economists called the, S&P Index Committee, who select the companies who appear in the index. These experts examine numerous elements of a company’s financials to determine if they are a fit for the overall index. The committee uses a market capitalization method to provide larger valued companies a greater weight in the index.
S&P 500 Investment Opportunities
For investors interested in investing specifically in the S&P 500, should understand that it’s incredibly difficult to replicate its actual portfolio of 500 stocks. For that reason a few financial institutions have created exchange traded funds (ETF) that provide the best representation of the index. An investor can choose between the Vanguard S&P 500 ETF, the SPDR S&P 500 ETF or iShares S&P 500 Index ETF.
The Beauty of Compounding
The ever so wonderful engine of compounding is a mechanism that allows your money to continuously build upon itself again and again over time. Metaphorically it’s like a snowball rolling downhill. Essentially, the compounding mechanism generates income on its own through earnings that were reinvested into the initial asset. All an investor needs to do is reinvest any earnings and allow the asset to grow over time. Allow the compounding to take a life of its own by holding onto it for as long as possible. This will provide increased earnings each year as the original investment plus reinvested income continues to accumulate.
Let’s look at an example:
Say you invest $5,000 today with an 8% annual return rate, you would have $5,400 after year one (5,000 x 1.08). Instead of taking out the $400 profit, you leave it untouched and reinvested for a second year. After year two, your new balance would be $5,832 (5,400 x 1.08). In year one the profit was $400 and year two saw a profit of $432. Just in the second year your investment increased $32 above year one’s return and this is because the initial returns were added to the second year of compounding. The effort that you had to put in was zero and sure the differences are nominal, but remember over the long-term the compounding returns will continue to grow exponentially.
After three years, the initial investment could be $6,299 ($467 in profit and $35 more than year two). Now after the fourth year, the investment could roll to $6,802 ($503 in profit and $36 more than year three). Finally, after five years the balance could grow to $7,347 ($545 in profit and $42 more than year four). So, with reinvesting your earnings, after five years your investment would be $7,347 with results of $2,347 of profits earned from the original $5,000 and nearly a 50% total return. If someone didn’t reinvest any earnings each year, their profits would be lower at $2,000. The longer you reinvest earnings, the stronger the compounding will kick in.
In case there is doubt that remains in your mind on the basis of earning an 8% return annually from investing in the S&P 500 Index, here is a chart showing the annual returns for the past twenty (20) years from 1996 – 2015.
The Numbers Speak for Themselves
As you can see over the 20 years, there were 12 years where a greater than 10% return was seen. Yes, there were four years with negative gains, but that’s only 4 out of 20 years. The 2008 market crash is certainly eye-popping with a 36.55% loss, which was a time that affected everyone, across the board, not just stock market investors. The housing market was also hurt badly by devaluation of properties, and the overall economy took a massive hit to consumer spending. However, the S&P 500 bounced back with returns of 25.94% in 2009 and 14.82% in 2010.
Investing for the long-term isn’t about year to year results; it’s about the end goal, the ultimate destination. Over the twenty (20) years the index has returned, with dividends reinvested, a total of 380% to investors. For simplicity, for every $100 invested at the beginning of 1996, it would have risen to $480. Just as every $1,000 would have grown into $4,800. And every $10,000 would have returned $48,000. But keep in mind this does not include any other contributions that were made throughout the 20 years. This simply illustrates how a gain of 380% can strongly change your investment position. Imagine the returns if there were additional contributions over the twenty years.
Say your attention isn’t on a 20-year spectrum; rather it’s on how much return could be seen on an annualized basis. That’s totally reasonable if you do not have two decades left in your savings plan or you actually have 25, 30 years to go before retirement. Analyzing the same 20 year period of the S&P 500 Index with dividends reinvested, its annualized return settled at 8.20%. Some years will bring in a negative or modest return, and some years will have higher return on investment rates than others, but the overall performance will always average out to a strong result over the long haul.
The compound effect is a proven mechanism that will allow a person’s portfolio to grow exponentially over time. It’s incredibly difficult to save your way to the millionaire dollar status. Most people do not have the monetary resources, and certainly do not have the time. Even if there were $500 available in your monthly budget to set aside every single month for as long as you wanted, it would take nearly 167 years to finally reach seven digits. Please let me know when you’ve meet a person who has reached the age of 167. Sure 167 years seems idiotic to even include as an example, but I ask how many people even have $500 to set aside every month for financial goals?
It’s a matter of putting everything into perspective. The majority of blue or white-collar workers cannot simply save their way to a satisfying retirement; the instrument has to be investing. Nobody knows how long they will be physically able to produce a consistent income. Just as time is on your side when it comes to compounding, it works against you if you choose to start investing late or are too stingy with your contributions.