Jeremy Siegel, Ph.D. The Future for Investors

One of the most common pieces of advice stock investors hear is the importance of "updating" their equity portfolios to keep in step with the ever-changing economy. As older industries shrink, the conventional wisdom goes, one should weed out those stocks in declining industries like steel manufacturers, chemical firms, paper producers, and railroads and add new firms in industries that are expanding. Advocates of updating point out that all the popular stocks indices, from the Dow-Jones Industrials through the S&P 500 Index, routinely add new companies and delete old ones to keep their index representative of the changing economy.

Despite the ubiquity of this advice, I had seen little empirical evidencing documenting this claim. To determine by how much investors would lag behind the popular indices if they never updated their portfolios, Jeremy Schwartz, Senior Analyst at WisdomTree Investments (for whom I act as Senior Investment Strategist), and I investigated the returns of the original 500 stocks placed in Standard & Poor's 500 Index. These results are published as the lead article in the January 2006 issue of the Financial Analysts Journal and in my book, The Future for Investors.

The S&P 500 index is a market capitalization-weighted index of 500 firms that have satisfied certain earnings and liquidity criteria and was first calculated on March 1, 1957. Previously, the S&P Composite Index, calculated from December 31, 1925, included only 90 stocks but was expanded to represent more fully the performance of the broad market in the 1957 index.

Today firms belonging to the S&P 500 index constitute more than 80% of the value of all U.S. stocks, and it is estimated that more than $1 trillion are invested in mutual funds, exchange-traded funds and private investment pools designed to replicate its returns.

By no means is the S&P 500 Index a static group of firms. On average about 20 new stocks are added to the index each year, and an equal number of firms are removed that merge, go bankrupt, or fall below S&P's standards. Over the nearly 50 year history of the S&P 500 Index, almost one thousand new firms have been added and one thousand old firms deleted.

When one looked at the first 500 firms that were placed in the index, it seemed likely that the returns on these firms would lag behind those in an actively updated index. In 1957 the largest sector was the "materials" industry, which contained such erstwhile giants as DuPont, Union Carbide, Alcoa, U.S. Steel, and Bethlehem Steel.

In contrast, the biggest growth sectors over the past half century were the technology, financial and health care sectors. In 1957 they added up to less than 5% of the market value of the index while today these three sectors comprise almost half the value of all S&P 500 firms.

Surprising Results

Despite our expectations of lagging returns from a portfolio of the 500 original firms, the actual returns proved superior. From March 1, 1957 through December 31, 2003, the buy-and-hold portfolio of original 500 stocks returned 11.4% a year versus 10.85% for the continually-updated S&P 500 Index, and did so with a lower risk (standard deviation) of 16.09% versus 17.02% for the updated S&P Index.

Beating the continually-updated S&P 500 Index is no mean feat. Essentially every empirical study has shown that equity managers, after fees, have been unable to outperform the S&P 500 Index over long periods. Imagine buying those 500 stocks in 1957, instructing each firm to reinvest cash dividends in new shares (called DRIP, or dividend-reinvestment plans), and then do absolutely nothing to your portfolio for the next half century. Yet when you sell those stocks nearly 50 years later, you would have outperformed most professional money managers!

Why did this happen? First, many of the original firms delivered good returns, even if they were in a shrinking industry. Although returns in the materials sector were sub-par, those in the energy sector were above average - despite the fact energy shrunk from over 20% of the index in 1957 to just 6% of the index by 2003. And our studies only went through December 31, 2003, well before the latest surge in oil prices.

As long as firms in shrinking industries were churning out cash and returning it to shareholders in the form of healthy dividends, these stocks provided excellent long term returns. Remember how my Yahoo column "Beware of the Growth Trap" compared the long-term returns of Standard Oil of New Jersey and IBM? The outperformance of the original S&P 500 firms is the same story.

In contrast, firms in expanding industries performed relatively poorly. Recall that a stock gets added to the Index when its market value qualifies it as the top 500 and it passes certain earnings and liquidity criteria. But stocks that rise in market value often do so because of over-optimism on the part of investors and other reasons unrelated to basic valuation of the firm. These overvalued stocks are not the ones that you want to buy and hold.

Portfolio Advice

Despite our surprising results, I don't recommend that you go out and buy the current 500 stocks in the S&P 500 Index and just hold on to these over the next several decades. A buy-and-hold portfolio which never adds any new stocks will eventually become unbalanced and exposes investors to risks that a more diversified portfolio would avoid.

Nevertheless, the research did debunk those who insist that updating is essential or maintain that actively managing your equity portfolio is necessary to obtain the good returns in the market. Neither is true. Running after stocks in the "next big thing" generally proves to be a disastrous investment policy. Many firms in static or even declining industries outperform the market. Ask the top money managers, such as Peter Lynch and Warren Buffett where they look for their best stocks.

In the next column I will tell you which of the 500 original firms performed best for their long-term investors. Studying their characteristics gives investors a good idea of what they should seek in the stocks that they intend to hold as a part of their long-term portfolio.