Just this last week a young relative contacted me wondering what to do with a large amount of cash that had accumulated in their account over the past couple years. Up until now, my young relative had shown no interest in investing. They have a very demanding and time-consuming job and, like many young people, they thought that learning about investing would be an unpleasant chore, very much like filling out tax forms.
But inflation has picked up to where even my oblivious relative had noticed that prices were soaring at the grocery store. They had also just noticed that a money market fund, which had been paying over 2% just a few years ago, was paying nothing and that they could not find CDs paying anything to replace matured CDs.
So my relative wanted me to tell them, in as simple terms as possible, how to invest their cash so that it would keep up with inflation. Should they just put it into an index fund that tracks the stock market like the Vanguard S&P 500 ETF (NYSEARCA:VOO)? I've been mulling over how to answer ever since.
Naive Investors Want Simple Investing Solutions
I'm sure that as soon as you got the reputation among friends and family of being an astute investor you also faced this same question. And I'm also sure that if you tried to give a thoughtful, well-reasoned answer you've seen your questioner's eyes glaze over very shortly after you began.
The truth is that while people those who read articles on Seeking Alpha daily find investing fascinating, a large part of the world sees investing as just another hobby embraced by enthusiasts that is utterly boring to everyone else.
That's why when they ask you what to invest in, most people just want an answer no longer than a sentence or two. Anything longer affects them the way a scene-by-scene analysis of the new Dune movie might strike you if you don't enjoy SF or how you might feel when a friend launches into an inning by inning analysis of what is wrong with Red Sox pitching when you don't follow baseball. You just want to know if the movie was any good or if the Sox are going to win another World Series.
So with that in mind, I knew that I'd have to keep my advice to my young relative short and very simple. And what is shorter and simpler than telling them, "Yes, buy VOO?"
It's not a bad answer. Study after study has confirmed that few investors, no matter how skilled can consistently beat the performance of the S&P 500 over a period longer than 10 years. We are all familiar by now with Warren Buffett's famous advice to his stockholders, "My regular recommendation has been a low-cost S&P 500 index fund." And we know he put his money where his mouth was, too, when he made a million-dollar bet with hedge fund managers that, over 10 years, he could beat their results simply by owning an S&P 500 index fund - which he did.
So Investing in VOO could be a perfect solution for people who are forced to invest but don't want to "waste" their valuable time studying the ins and outs of investing.
It's Not Quite that Easy
What keeps me from giving that advice and letting it go at that is this: I was given that same advice back in the 1980s when I, too, assumed that investing was something only elderly bores found interesting. I even followed that advice. There was only one problem: I had no idea what an index fund really was and how it might behave. So when the market plunged 20% on "Black Monday" in 1987, it scared the pants off me and I stopped investing.
You might just shrug and say, "Well, you were an idiot. Lots of people held on to their index funds and are now enjoying comfortable retirements 35 years later." And you might be right. But a quick scan of the investing sites frequented by young people, including the Bogleheads reddit where enthusiastic proponents of index fund investing hang out, suggests I am not alone.
Quite a few young investors are enthusiastic about buying broad market index funds right now, but their comments make it clear they are enthusiastic largely because they believe that investing in index funds is safe and that their investment can be expected to grow by at least 7%-10% a year.
They didn't pull those numbers out of midair. They are bandied about by fund companies, investment advisors, and websites like nerdwallet - based, of course, on the past performance of the S&P 500.
Looking more closely, it becomes clear that these investors have only the foggiest idea of what they are buying when they buy an ETF like VOO. They know it holds "all the stocks in the market" but they don't realize that the ETF is market cap-weighted and that means that no matter how many stocks it holds, only a very small subset actually affect its price movement - a topic I have written about extensively here on Seeking Alpha over the past few months.
Very few have any idea what valuation means or why it might matter. Terms like "P/E ratio" or "valuation" are meaningless to them. They tell each other just buy the index fund and chill.
But can these new investors chill if the market enters another period similar to the one that followed the irrationally exuberant 1990s? One where the market drops and seems to recover after seven years only to plunge again? We all know investors who pulled their money out of the market in 2008 when the market dropped and never got back in - missing out on gains that could have made their retirement years far more comfortable.
The Market - and VOO - Is Now At A Valuation Way Too Reminiscent of the Year 2000
To address I have written extensively about how VOO is constructed in an earlier article, VOO vs. VTI Smackdown. So I won't repeat that information here. I do urge you to read that article you are a young person considering investing in VOO as it will greatly help you understand what you are buying when you buy a share of VOO.
VOO's Share Price is Heavily Influenced by a Small Number of Stocks
I have also written at some length about the growing top-heaviness of all market cap-weighted ETFs in other recent articles.
Vanguard tells us that though VOO holds 510 stocks right now, as of September 30, the top 10 stocks made up 29.2% of its total assets.
Source: Vanguard.com Note: Vanguard counts GOOG and GOOGL as one stock
When I downloaded the complete list of holdings from Vanguard's advisor site I found that the top 50 stocks by market cap weight made up 53.6% of the value of VOO. More disturbingly, the bottom 100 stocks held in VOO only make up 2.55% of the value of the entire ETF.
This kind of over-weighting works very well when the top stocks in the index are soaring as they have been the last year or so. But it also leaves ETF holders very vulnerable if the market changes its mind about the value of that small number of top stocks.
Valuations are Stretched
Vanguard gives us this information about the fundamentals of the stocks in VOO.
However, as is almost always the case with Vanguard, the company does not tell us how these fundamentals are computed, so it is hard to know if they have just averaged the P/E ratios of the 510 stocks held in varying amounts or used the cap weighting to derive the P/E ratio.
For that reason, I used FastGraphs to take a quick look at some valuation data for VOO's top 10 holdings, which as you will remember make up 29.2% of the ETF's entire value.
Top 10 VOO Stocks - Some Valuation Metrics as of 9/30/2021
Source: fastgraphs.com data from FactSet and S&P Global, table by the author.
As you can see the P/E ratios these top 10 stocks are, with the exceptions of Johnson & Johnson (JNJ) and JPMorgan Chase (JPM) considerably higher than the 24.3 P/E ratio that Vanguard reports for the ETF as a whole.
Half of these top stocks have P/E ratios well above their 5-year average P/E ratios. The two stocks that have lower P/E ratios than their 5-year averages are Amazon (AMZN) and Tesla (TSLA), which are stocks whose P/E ratios have been extreme in the past and are still at levels that suggest that the market is expecting triple-digit growth for years to come.
Their current prices have already attained the heights analysts expect them to reach in 1 or 5 years. Only JPMorgan Chase & Co is currently priced at a level below what analysts predict its price will be in those time frames.
Stretched S&P 500 Valuations in 2000 Led to a Long Period of Poor Returns
It is difficult not to compare the current state of the S&P 500 with its condition in 2000 when it was about to begin a long decline after the exuberant years of the dot.com boom.
To remind you just how bad the S&P 500's performance was after that decline began let's look at the performance of the Vanguard index fund that tracked the same index as VOO during that period. (VOO only started trading in September 2010, after the decade of stock market stagnation and carnage was over.) In the chart below you can see the price history of The Vanguard 500 Index Fund Admiral Shares (VFIAX) which is the mutual fund class of VOO.
Vanguard 500 Index Fund Performance Sept 2000-Jan 2010
Source: Marketwatch.com
VFIAX's share price was $121.86 when the market opened on the first day it traded in September 2000 - which was already after the S&P had begun its slow decline. Almost a decade later, its price was $107.73 when the market opened for the first day of trading in January of 2010.
In between those two low points, the share price of VFIAX reached a high in July of 2007 of $140.62, which represented a gain of 15.4% over the 2000 starting price. But investors who had bought in 2000 were still looking at an 11.6% loss.
We all know investors who pulled their money out of the market in 2008 when the market dropped and never got back in. How would today's enthusiastic young person who was expecting to earn a relatively safe average 7% annual gain respond to seeing their investment shrink for a period that long?
It took 14 years for investors to see their investment in VFIAX (which you must remember is just another version of VOO) get back to even. That's a long time.
Whether we are going to see another long period of decline and stagnation is something none of us know. The relatively quick recovery from the 2008 Financial Crisis and the lightning fast recovery from the March 2020 COVID-19 swoon have given younger investors the message that the market will henceforth bounce back from even the most severe declines. If that turns out not to be the case, young investors who put 100% of their assets into VOO (as many reports they are doing on the Bogleheads Forum) are in for a very long and painful test of their ability to buy and hold.
If the past is any guide to the future, many will fail.
Dividends Didn't Make Up For the Price Stagnation of the 2000s and They Won't If It Repeats
A lot of arguments are made to convince young investors that this time is different. One is that the high P/E ratios we see in the S&P 500 right now are justified by the interventions of the Federal Reserve which have kept interest rates locked at historically unheard of lows. The lack of an alternative in fixed income investments has pushed conservative investors into stocks, it is true.
But if inflation persists and the Fed is forced to raise rates, that could change. And if rates do rise, and investors rush out of stocks into fixed income products offering yields that keep up with inflation, the dividends paid by the S&P 500 will not do much to improve the miserable performance investors may experience.
We are told that despite the poor performance of the S&P 500 in the highly inflationary 1966-1982 period, dividends still made stock investing profitable. You can read a summary of the data that shows this in this article on the Wealth of Common Sense blog. Over this period dividends indeed contributed to three quarters of the total return of the market.
But this was true only because the prices of stocks in this period were significantly depressed. The P/E of the S&P 500 at the start of 1982 was 7.72. Those historically low prices relative to earnings made for higher dividend yields.
In 2000 the story was very different. In January 2000 the S&P 500's P/E ratio was 29.04. FastGraphs provides a useful feature that lets us see the exact amount that dividends contributed to the total return of the S&P 500 from 2001 to the end of 2009. (FastGraphs does not display data prior to that date).
Source: fastgraphs.com
As you can see, from 2001 to the beginning of 2010 dividends contributed 1.9% to the total return of the S&P 500, offsetting the greater loss, but the total return was still negative. Note, however, that this analysis starts at a time when the S&P 500 had already dropped by 21% from its price at the start of January 2000.
The dividend yield of the S&P 500 at the start of the period for which FastGraphs reports data was 1.39%. The dividend yield of VOO right now is at an even lower level: 1.26%. Even if dividends were to grow at a rapid pace over the next decade, that low starting yield would keep dividends from contributing more than 2% to the total return.
Investing in VOO Only Makes Sense Now if the Investor Really Can Buy and Hold for Literal Decades
Of course, we all know, with perfect hindsight, that investors who bought at the top of the market in 2000 and had the fortitude to hold on to their investments have done very well for themselves.
The table below shows you that indeed, investors who bought and held from August of 2001 to the present unlike those who only held for a decade did receive a 7.3% annual return for the entire 20 years period - which is what young investors expect today.
Source: fastgraphs.com
What Past Buyers Were Able to Buy and Hold?
One thing I have learned from reading messages posted on the Boglehead investment forum for the past eight years is that the investors who have bought and held the broad market indexes like VOO for those necessary decades are almost always investors who started out investing in individual stocks.
This fact often goes under the radar, especially since these investors are the ones more likely to tell young investors, "Don't invest in individual stocks." But what they miss is how much they learned about stocks and stock behavior during the years when they invested in those individual stocks.
Yes, they may have learned - as I did myself when I analyzed my results after several years of buying individual stocks - that their returns from stock-picking were close enough to those of an S&P 500 fund or ETF like VOO to make it questionable whether the time spent researching those individual stocks was worth it.
But when those experienced investors threw in the towel and began buying index funds, they knew what a stock was, how earnings results impacted the movement of those stocks, how economic factors affected their prices, how media hysteria and the financial news channels exaggerated threats to their portfolios in the endless hunt for eyeballs, and how investing fads came and went, changing the makeup of the S&P 500 and changing what stocks were driving the market both higher and lower.
Investors who have bought get rich quick momentum stocks that cratered learned lessons that help them understand why a broad market index like the S&P 500 will correct after its top holdings have had their prices pushed up by momentum traders who ignore fundamentals but eventually move on to some new bright and shiny thing, leaving the previous momentum stocks licking their wounds.
In short, when these investors buy VOO, they know what they own and they have a realistic idea of how an ETF like VOO will behave. They do not put 100% of their investment dollars into stocks. They know there will be lean times and that those times can be very lean, indeed. They also know that it is at those very worst times in the market that an invested dollar is likely to provide the greatest returns for patient investors, making it important to preserve "dry powder" with which to invest at market lows.
So what does this tell us? It tells us that there is no shortcut to investing wisely no matter what a person invests in. Investors do best when buying an indexed product when they know what it is they are buying, understand which stocks are in their ETF, and how they are likely to behave in the next four or five years, even if those stocks are packaged in the form of an ETF or mutual fund.
So there is no way around it. I'm going to carefully explain to my young relative that yes, they should invest in VOO - but only money they can afford to leave alone for 20 years. And that the best way to invest is slowly and carefully - not investing a large sum all at once, but scaling in, month after month. And as they do this, they must commit to finding the time, as hard as that might seem, to familiarize themselves with the basics of investing: How markets work, how stock prices relate to company earnings, how VOO invests, and how they can expect it to respond to different kinds of economic shocks.
Below is a very quick summary of the advice I will be giving.
TL;DR Advice for Young People Investing in VOO
1. Before you buy VOO any ETF familiarize yourself with the basic investing concepts necessary to understand what you will be buying. The time you spend will be worth hundreds of thousands of dollars to you over the next decades. And you might even discover that investing is far from boring.
- Learn what it means that an ETF "follows an index" and how the index it follows is constructed.
- Learn what market capitalization means and how it influences how much of each stock your dollar is buying when you buy a dollar's worth of an ETF.
- Learn why the relationship between a company's price and its earnings matters and what terms like P/E ratio, earnings growth rate, and ROE mean.
- Learn what's behind the terminology used to describe stock investments. Some words have very specific meanings when applied to stocks that are different from what they mean in ordinary conversation. Among the most important of these are "Growth," "Value," "Cash Flow," "Momentum," "Meme," and "Sector. Invest small amounts at a time even if you have a large amount to invest
2. If investing a large amount of saved-up cash, invest a small portion every month to make it less likely that you will invest all your money at a market peak followed by a long decline like that which began in January 2000. Investing slowly gives you time to observe how the market behaves and get more comfortable with the market's periodic upheavals.
- The larger the amount you have to invest, the longer the period you should stretch out your investing.
- Never invest money in stocks that you might need to spend over the next decade to cover emergencies, a prolonged period of unemployment, a devastating diagnosis, or a natural catastrophe. You don't want to have to take large sums of your invested money out of the market at a time like the fall of 2008 or late March 2020.
3. Always maintain at least one-third of the money you have available for investing in some form of fixed income, be it a money market fund, CDs, or a bond fund-but buy bond funds only after you have studied up on how bond prices respond to changes in interest rates. Having a fixed income cushion gives you the "dry powder" you need to buy more shares when the market crashes and other investors panic. It also protects you from panicking yourself.
4. If investing your money in a taxable account learn what Tax Loss Harvesting is. Selling VOO at a loss after a severe market drop and immediately buying into an indexed product that follows a different index with similar performance like the Vanguard Total Stock Market (VTI) can provide you with losses you can use to write off thousands of dollars of future gains. This takes some of the pain away from large drops in VOO's value.
This article was written by
Psycho Analyst
5.97K
Follower
s
Though I have done quite a few different things over the course of a long life, I am best known as a writer of bestselling books about business and health. My success has come because I am a very curious person who doesn't just follow the herd and trust whatever the experts tell us to believe. I do my own research. I collect the facts, look at them objectively, and draw my own conclusions. Over the years, I have been amazed at how much of what everybody "knows to be true" is based on poorly designed studies, many of them impossible to replicate. I approach Investing with the same open mind, challenging the orthodoxies that attract the herd, studying how things really work, and doing my best to come up with an approach, based on facts, that works for me and would appeal to those who find thinking worthwhile. Lately I have been investigating how the indexes that underlie ETFs are constructed and finding out in the process that the way these indexes are set up guarantees that many of the ETFs people buy are not really doing what their titles suggest they do. I am also doing my best, in the current very challenging environment, to find relatively safe ways to deploy the money I use to generate income, money that I would normally put into CDs. I use valuation concepts and a liberal sprinkling of common sense to find stocks that I believe will not only produce modest amounts of income, but also grow their share price over the next five years.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I don't currently own VOO but have owned it in the past and use it as a tax loss harvesting partner with VTI.
