Can You Beat the S&P 500?

Cyrus asks, “Can you beat the S&P 500?” Specifically, he references how Dave Ramsey has said on his show that it is “easy to find funds that outperform the S&P 500.” Is this true? And if it is so easy, why doesn’t everyone do it?

I did provide an answer to this three years ago in Episode 8: How to Be Above Average. However, that episode is rather long, and there is plenty more to say about it. If this topic interests you, I’d recommend going back to listen to that episode as well as this one. We also just discussed last week the flip-side of this equation, “What if My Investment Performance is Worse Than the S&P 500.” Check that out, too.

(Remember that you can submit your questions to the show by emailing us at Questions@RetireMentorship.com or by visiting RetireMentorship.com/Question.)

It’s “Easy” to Beat the S&P?

I don’t know how often Dave Ramsey says this. Presumably, Cyrus heard it recently, and though I don’t listen to Dave anymore, I remember him saying it several times when I was a regular listener. Is it really “easy to find funds that outperform the S&P?”

Outperformed

Let me make a crystal clear distinction. There is a world of difference between funds that have outperformed the S&P 500 (past tense) and those that outperform (present progressive) the S&P 500.

It is easy to find funds that have outperformed the S&P. However, there is no evidence for the persistence of performance. Those funds that have outperformed may have done so for two reasons.

Outperformance Within a Period

It’s incredibly easy to find funds that have outperformed over a period. If you compare 1, 3, 5, or even 10-year periods, you can find funds that have done better. The shorter the timeframe, the easier it is to find better funds. But often, if you extend or shorten timeframe, you’ll see that they haven’t done better. What do I mean?

Extend the Period

Let’s say you find a fund outperforming the S&P 500 over the last 1, 3, and even 5-year periods. “Great!” you think. “Here’s one of those outperforming funds.” But then you look at the 10-year period, and it is underperforming. What does that tell you? Has it found the magical formula within the last five years for outperformance in the future? Or have they just gotten lucky recently?

We do not care what the fund did in the past. We only care about what it will do in the future. Will the fund perform like its 5-year performance? Or will it perform like its 10-year performance? There is no way to know.

Shorten the Period

Maybe you find a fund that has outperformed over the last ten years and “since inception.” Awesome! You’ve found one of these funds Dave Ramsey talks about. You know you’re not just looking at recent performance but rather long-term performance! And it has outperformed over the long term!

But then you notice that its 1, 3, and 5-year performance is below the S&P 500. Lately, it is consistently underperforming the market. How?

This fund could have easily gotten luck in the early years, creating such great initial performance that the initial luck keeps it looking good. But it may be more likely that its recent underperformance will continue into the future than its initial luck.

Survival Bias

Investment funds (mutual funds and ETFs) have a definite survival bias. I covered this in Episode 8 in more detail, but I’ll give you a short version. A company may release ten new funds to the public. Nine of them severely underperform and are closed down. One gets lucky early and “outperforms.” That initial luck covers over a multitude of investing sins in the future, allowing that fund to appear as though it is a great fund that consistently outperforms the market. Instead, it was the lucky one, the loan survivor among unlucky failures, and its past performance does not indicate future success.

Past Performance Does Not Guarantee Future Success

There is a disclaimer on all investments. “Past performance does not guarantee future performance.” In most cases, it does not even indicate future performance. There is no evidence of the persistence of performance.

Dave Ramsey is Wrong

Dave Ramsey is wrong on this. Episodes 9 and 10: “Is Dave Ramsey Wrong?” cover Dave’s controversial statements, some of which I agree with and others I do not. We can add this item to the list of wrong statements.

It is not easy to find these funds. While it is easy to find better past performance,it is impossible to find funds that outperform the S&P 500. Why? Because there are no facts about the future.

Can You Beat the S&P 500?

So it’s not easy. But is it possible? Yes. Maybe.

It Depends

There are periods when fund other equity indexes and funds have outperformed. It is logical to assume they will do so in the future. The problem is that there is no way to know which funds or indexes will outperform in the future.

It depends on two things:

It Depends on the Index

The S&P 500 is an index (list) of the 500 largest companies in the U.S. But it’s not the only index. There are many other indexes and classes of companies that also perform well.

The biggest companies in the U.S. have some advantages regarding other continued growth and profitability. They didn’t get there by being stupid, so it’s reasonable to assume that the companies will continue to be profitable and grow. Thus, these companies are a great list to co-own.

But in some ways, buying the S&P is “buying high.” Think about it. You are buying the biggest companies only after they have become big. Every company on that list started small and had tremendous growth to reach that status. If you wait until they reach the list, you buy them at the top. They may keep going, but you are certainly missing out on a lot of growth along the way.

There are other indexes, notably of “Small Cap” and “Mid Cap” companies. Every S&P company was once a part of these indexes until they outgrew them. Wouldn’t you have liked to have owned Amazon or Apple before they reached their behemoth status now? If you have always owed Small- and Mid-Cap indexes, you did. You owned them through the small, mid, and large sizes and benefited from that early growth.

Not all Small companies make the S&P 500. But each of the 500 started small. Diversifying out of the largest companies allows you to harness that growth. Many other indexes have performed similarly to the S&P 500 over long periods, and others haven’t come close.

It Depends on the Period

The period you measure returns in dramatically impacts the results you get. Let’s look at some examples of Large-Cap and Small-Cap index returns. Consider these returns (all numbers are as of December 31 of the indicated year):

Ten-Year Returns Ending 2023

• Large Cap: 11.8
• Small Cap: 8.3

Okay, that’s a big difference. So, a Large Cap is a better investment, right? What about the period before it?

Ten-Year Returns Ending 2013

• Large Cap: 7.3%
• Small Cap: 10.2%

Oh. Maybe not. That is a similar spread the other way. So, which has the edge? Let’s combine the periods.

Twenty-Year Returns Ending 2023

• Large Cap: 9.56%
• Small Cap: 9.25%

Okay, a Large Cap has a slight lead. But what if we back it up just one year?

Twenty-Year Returns Ending 2022

• Large Cap: 9.66%
• Small Cap: 10.40%

Wait, what!? Large Cap has a 0.3% lead ending 2023, but Small Cap has a 0.75% lead if you shift it back just one year!

And you see similar differences if you use 15-year periods, 30-year periods, 19-year periods, and many more. When you measure has a massive impact on the results you get.

There is No Evidence of the Persistence of Performance

We keep coming back to this because it continues to be true.

Large-Cap Funds, especially Large-Cap-Growth Funds, have done well over the last ten years. But that doesn’t mean they will do well over the next! Small Cap had a 3% surplus to Large Cap for ten years, then proceeded to “underperform” by 3% the next ten. Will Large Cap continue to be the best going forward? Maybe. Or they might underperform going forward. No one knows.

Again… Can You Beat the S&P 500 or Not?

For the ten years we discussed, anyone investing in Small Cap Index Funds beat the S&P 500. That’s just one example. There are numerous examples of periods where other indexes have beaten the S&P 500 and other periods where the S&P beat basically everything else.

So, yes, you can beat the S&P 500 because other indexes will eventually beat it. You just can’t know which ones will and when. No one can.

The Strategy That Gives Us the Best Chance

There is a strategy that gives us the best chance of outperformance. Unfortunately for this audience, I can’t tell you what it is because it bleeds too much into investment advice, and I’m legally not allowed to give investment advice to the general public.

If you’re a client of mine, we are already doing this. I’d happily give you a refresher on the strategy at any point. Since you’ve listened to this, that refresher will take less than five minutes.

If you’re not a client of mine, I explain the basics of the strategy during our 3D Evaluation Process, a couple of free meetings where we get to know each other and see if we should work together. That process ends with you sleeping on it and considering whether our services and this strategy are right for you. You can learn more by going to LaCrosseFinancialPlanning.com.

This article is educational only and is not intended to be investment, legal, or tax advice or recommendations, whether direct or incidental. Again, this is not investment advice. Consult your financial, tax, and legal professionals for specific advice related to your specific situation. Never take investment advice from someone who doesn’t know you and your specific situation. All opinions expressed in this article are those of the people expressing them. Any performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be directly invested in.