For many that have followed the market recently, this statement probably seems crazy. Since the market bottomed out in early 2009 following the financial crisis, the S&P 500 has basically gone straight up for the last 11+ years, averaging a 16.4% annualized return during that time period. It has finished up in every single calendar year except for a 4.4% decline in 2018 (which happened to be sandwiched between 22% and 31% gains). Even this year when the index was down > 30% in late March, it has rallied back and is up about 2% on the year.
So why is something that seemingly only goes up too risky? It’s first necessary to understand 3 important concepts:
1.) What does the S&P 500 represent?
2.) How is it constituted?
3.) What can the past tell us about the future?
When I talk with investors, I often ask the same question: “When you hear on the news that the market went up or down, do you know what they’re referring to?” Most people have a basic guess of the Dow or the S&P, but when prodded further, don’t really know what those mean. This isn’t to say they’re wrong or ignorant; it’s been engrained in all of us that those two indices are a good proxy for “the market”. The reality is that there are around 600,000 publicly traded companies in the world and close to 20,000 in the US alone. The Dow represents 30 of these and the S&P obviously represents 500, all of which are large corporations based in the US. Not only do they only represent a fraction of the overall companies, but they totally exclude small companies and all companies based outside of the US. Why is this important? Well, stocks with similar characteristics tend to move up together (which we’ve seen recently), but they also tend to move down together. More on that later.
The other hidden risk of the S&P 500 is how it is constituted, specifically that it is market cap weighted. This means that the bigger the company (based on share price * total shares), the more weight it represents. So while holding only 500 large, growth oriented US stocks is already a concentrated bet, the reality is much worse. While technically it does represent 500 unique stocks, the vast majority of those carry very little weight and have almost no impact on the return of the index. The chart below shows just how top heavy it is.
The top 37 companies constitute 50% of the index, while only 5 companies make up nearly a quarter. What are those 5 companies? Apple, Microsoft, Amazon, Google, and Facebook. The most common advice preached by investment professionals is diversify and don’t chase what’s hot. This often leads to the recommendation to just go buy a low-cost S&P 500 index fund. This is generally good advice, but let’s recap what an investor actually holds in this scenario:
25% of their portfolio in 5 tech companies based in the Pacific Northwest of the US with very similar fundamental characteristics
50% of their portfolio in just 37 companies
0% representation to small companies, value companies, and those based in developed or emerging market countries
That is not great diversification.
There’s one additional consequence of this way of constituting. Because the market cap of companies increases as their stock price grows, this results in the index not only becoming top heavy, but one where the top is overweighted with stocks/sectors that have run-up recently. In times like we’ve seen recently where there has been a great disparity between the performance of those bigger holdings, this can become magnified. Those currently invested solely in the S&P 500 are unintentionally breaking the two cardinal rules of investing: they are under-diversified and overweighted in what’s hot.
Consider what we’ve seen over the last few years.
Since the start of 2018, those top 5 stocks have gone on an amazing run, returning over 130%. Remember that those 5 companies comprise almost 25% of the index. The impact this had on the S&P 500 can be seen when comparing the regular index with an equal weighted measure (all 500 stocks held in equal weight), where the regular market cap weighted index more than doubled the return.
This is important because we’ve seen an analogous situation only one other time in recent history where there was a top heavy concentration of stocks and a recent divergence where the cap weighted index significantly outperformed the equal weighted, and this was in the late 90’s.
For the 2 years from 03/1998 to 03/2000, we saw this divergence of the cap-weighted index outperforming equal-weighted by over 30% in just 2 years, driven by several large tech companies with outrageous returns. Sound familiar? For those following the market at this time, you remember what came next.
The tech bubble crashed and the bottom fell out of many of these large positions in the index. Over the next decade, the S&P 500 actually declined 11% – its worst decade since the great depression. However, the equal-weighted version of the index actually made 66% over that time period, not a bad return. By (unintentionally) making big bets on a small number of hot companies, many investors during this time suffered a steep and prolonged decline in their portfolio values. A similar risk is present in the market now, so my advice is to learn from the past and don’t underestimate the risk of the S&P 500.
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