Halloween’s come and gone, but it still stands out as my kids’ favorite holiday.
The older they get, the more the holiday spirit (or should I say, spirits?) seem to grab hold of them. They can’t get enough of the spooky and the scary, and one of their favorite running gags this time of year is “What’s under the bed?”
It’s a classic one, but it holds up — until you pull back the covers and take a look, anything could be under there. Killer clown? Godzilla? Nicolas Cage? Imaginations run wild.
Inevitably, one of my kids can’t stand it anymore and has to take a peek. Of course, there’s nothing there, and this always brings a sigh of relief and a return to reality. But, they don’t know until they check.
When I hear people talk about the stock indexes they’re investing in, I can’t help but draw a comparison. Why? Because most haven’t taken the time to get down on their hands and knees and take a look at what they’re actually buying.
Looking for Monsters
Investors love to talk about how diversified their index investments are. After all, the concept is sound: spread the risk, and limit your exposure to a market downturn.
But, when was the last time you actually took a look inside those indexes to see the specifics of how they’re put together? Almost all indexes are heavily weighted towards their “heavy hitter” components, either by market cap or price.
Take the S&P 500 index, for example (it actually has 505 positions). At first glance, this looks pretty good — 505 positions must provide a lot of diversification. And they do, especially in terms of industry and sector. However, the S&P 500 is “market cap weighted.”
If you’re unfamiliar with the term, all it means is the larger companies within those 505 positions represent a larger portion of the index’s performance. “Fine,” we say. “But just how concentrated are we talking here?”
Let’s take a look. In the S&P 500, the top 25 companies (that’s just 5% of the total 505 positions), account for a whopping 39% of the index’s performance. Extending this lens to the top 50 companies (roughly 10% of the index), and we’re now looking at a group that accounts for over half of the S&P 500’s overall performance. (Source: Barchart.com, November 1, 2019)
And here’s the real kicker: the bottom half of stocks in the index (250 companies!) account for only 12% of the index’s returns. (Source: Barchart.com, November 1, 2019)
Data sourced from Standard and Poors 11/19/2020.
I don’t know how you define diversification, but suddenly this makes the notion of “spread the risk” a lot shakier to me. The story of diversification across 505 stocks now has a big asterisk next to it. If you’re invested in indexes like this one, you might be less shielded from market fluctuation than you think. If Apple or Microsoft has a bad year, for example, or if small cap stocks bloom, you’re likely to see a lag in your performance. This issue isn’t isolated to the S&P 500, either. The Nasdaq 100 (QQQ) is similarly top-heavy: the top 20 stocks account for almost 70% of its performance. (Source: Barchart.com, November 1, 2019)
Now, don’t take this the wrong way — I’m not telling you to sell your index investments. But, you’ll always hear me say, “Know what you own.” Listening to people make lazy statements about the “diversification” of their indexes gives me a bit of a headache.
Remember, as you’re making decisions this coming year, make sure to look under the bed. Your imagination might be running free, with something very different taking place in reality.
Here’s to a fruitful 2020,
Tim
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held Twin Gryphon Advisors, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results.
Investment advisory services offered through Twin Gryphon Advisors, LLC, a registered investment advisor.
The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results. It does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.
The indices mentioned are unmanaged and cannot be directly invested into. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the US stock market.