Retired Investors: Let's Take A Closer Look At The S&P 500 Index Fund

Includes: SPY
by: Bob Wells

As many of you know, I'm a Dividend Growth Investor and have been assembling my Dividend Growth portfolio since the beginning of this year. That was not, however, the case when I retired from the federal government in 2008. I was part of the retirement investment program known as FERS. Under FERS, employees had limited investment choices. Each was connected to an index fund. The C fund tracked the S&P 500. The S Fund tracked the small cap index. The F fund tracked the Barclays Aggregate Bond Fund. Finally, the fund offered a fixed income option -- the G fund -- which invested in Government Securities. Most of my career, I was invested almost exclusively in the C Fund, or the S&P 500 index fund. For the first half of my federal service, things were great! From 1988 to 2000, there was only one down year for the index, and the average return for the 12-year period was 19.85%.

Then came a new decade and well, let's just say the next nine years were not as good. Down big in 2000, 2001, 2002 and of course, later in 2008. The average return for this period was (14.5%).

In late 2007 after watching the index move sideways, I decided to move all our funds to the G - (CASH) account and dodged the carnage that happened just before my retirement in August of 2008. It wasn't long into retirement when we started to realize that the income from our government securities account wasn't enough to financially support our retirement since we were utilizing the recommended 4% withdraw rule, even with two pensions and Social Security.

At first I considered moving back into the C fund, or maybe a combination of the C fund and the F, or aggregate bond fund. At least to me though, bonds seemed to come with risks moving forward, particularly as interest rates began to climb. With our pensions providing inflation adjusted fixed income along with Social Security, maybe it was time we looked at investing in the S&P 500 index again.

I confess, while I was with the federal government, I never really understood much about the S&P 500, other than that I was invested in the 500 largest companies in the market. Seemed it was time to take another look at the index.

I have since learned that the S&P 500 is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities, and is meant to reflect the risk/return characteristics of the large cap universe.

Companies included in the index are selected by the S&P Index Committee, a team of analysts and economists at Standard & Poor's. The S&P 500 is a market value weighted index -- each stock's weight is proportionate to its market value.

The index is a representative of nine separate stock sectors. As you can see from the following chart, each sector is not equally represented in the index with only two of the 10 sectors, Technology and Financial, making up over a third of the index.





Consumer Discretionary




Health Care




Consumer Staples






Click to enlarge

As I started to more vigorously explore investing, I began a serious study of the decade from 2002-2011. I discovered that technology and financial stocks played an important role in the huge losses suffered by the index in 2002 and 2008. Risk-averse investors like me who are drawing current income from their investments are likely to want to be under-represented in these two sectors. In fact, many I have heard from on these pages over the past year have strongly stated they would never invest in a bank stock again.

I learned that each of the 500 stocks are not equally represented in the index. Instead, the S&P 500 Index uses market capitalization to determine a stock's size in the portfolio. Under this model, I learned you're buying more of a stock as its stock price increases. Wait a minute, maybe I'm not tracking something. I had always heard I was supposed to buy low and sell high. On the other hand, when the share price gets cheaper, it becomes a smaller percentage of the index.

When I last checked last month, the index's top five holdings and fund weight percentages were as follows:






These five stocks account for over 13% of the entire 500 stock index. I was learning quickly that if I invested here, maybe I wasn't as fully diversified as I had hoped. Additionally, I was troubled by the high percentage of the index invested in technology and financials.

At the same time I was exploring the S&P 500 index option, I was first introduced to dividend stocks. I learned that according to Standard and Poor's, the dividend component has been historical responsible for 44% of the index's total return.

Since dividend yield was apparently going to be providing a large share of my retirement income, I was off to find out what the index has been yielding over the past decade. I was frankly surprised to learn it has only averaged 1.8% in dividend yield. Since I would need to withdraw 4% of my portfolio each year as the experts recommend, along with an amount equal to inflation, things were starting to look grim. When I looked at average return for the past 10 years, I discovered that the index averaged just 2.99%, including dividends. The average barely keeps up with inflation if you go back to 2000.

Am I suggesting that the S&P 500 index is a bad investment? Not really. Those invested in the index in the 90s like I was did well. I'm just saying that since I'm now retired with a low risk tolerance, it doesn't seem like right investment vehicle for me at this time, particularly since I don't see us returning to the bull markets of the 90s any time soon.

What I am strongly suggesting is that as a senior investor, you need to spend time really getting to know your personal risk tolerance and next, that you closely examine your investments, like index funds, to make sure they match with that level of tolerance. If you have mutual funds, look closely at the individual stocks that make up that fund. If you are risk averse, you may wish to stay away from funds with large numbers of stocks that have high beta or are more cyclical.

I find that Dividend Growth Investing works best for my risk tolerance and investing goals now that I'm retired. Since I'm not selling any of my holdings each month for income as I would have been doing if I were still invested in the S&P 500 Index, I have a better chance at preserving principal moving forward. Having a portfolio of stocks with safe dividends growing at a rate higher than inflation helps me sleep well at night during troubling times like these.

If you are retired or will be in the next few years and you haven't yet fully explored the Dividend Growth Investing option, here are three great articles to get you started:

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any 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.