The S&P 500 is more concentrated than you think

If you make orange juice from frozen concentrate you can mix it too strongly. Add only a little water, and it tastes too sugary, too tangy. Something similar is happening with the S&P 500 Index.* Lately, the index tastes funny. It’s too concentrated.

Because the S&P 500 Index is concentrated of late, too much of its return is coming from too few of its stocks.

“The S&P 500 has a big performance issue that should be a focus for investors,” says CNBC. “Too much of the index return is coming from too few of its stocks.”

What should you do?

A capitalization-weighted index

“The Standard & Poor’s 500 Composite Stock Price Index is intended to be a representative sample of leading companies in leading industries within the U.S. economy,” says the U.S. Securities and Exchange Commission (SEC). The stocks in the index are chosen for their market size, liquidity and industry group representation.

But let’s look and see how true that really is. Intuitively, it’s reasonable to think that if 500 stocks are supposed to give one a sense of how well those companies are doing, each company would represent 1/500th or 0.2% of the Index. But that’s not how it works at all. Instead, the Index is capitalization-weighted. By being capitalization-weighted, the S&P 500 is not an even split among the 500 companies comprising it. Instead, S&P 500 stocks are proportioned — the larger S&P 500 companies count more toward the index’s performance than the smaller companies.

“The top 100 stocks in the S&P 500 represent 64% of the index,” says InvestmentNews. The next 100 account for an additional 17%, and the remaining 300 account for just 19% of the index.”

Think about that. Just 20% of the companies make up 64% of the performance of the index. And 60% of the companies in the index account for less than 20% of its performance.

Recently, the largest of these companies have pulled ahead of the pack. Apple, the electronics company, has become huge. A number of banks have also grown in their market capitalization. Whereas the S&P 500 Index is supposed to be “a leading indicator of U.S. equities,” according to Investopedia, it’s more an indicator of a handful of U.S. equities of late.

Is concentration a problem?

The S&P 500 Index returned 11.6% annually over the last five years from June 2011 to May 2016 (including dividends), InvestmentNews says.

However, just 28 S&P 500 firms together produced more than half the total net income reported by U.S.-based companies in the index last year, says a USA Today and S&P Global Market Intelligence report. That means that just over 5% of the companies in the index provided more than 50% of the index’s income.

“How lopsided the index has become,” MarketWatch notes.

“The top 100 stocks in the S&P 500 are by far the most expensive stocks in the index,” InvestmentNews adds.

Thus, the performance of your S&P 500 investment dollars may be tied to fewer stocks than you realize. “This shift of profit into the hands of a shrinking group of companies is a danger for investors, who are now counting on fewer companies to deliver to keep the markets rising,” USA Today says.

Also, top-tier S&P 500 stocks tend to be pricy. InvestmentNews says that the price-to-earnings ratios of the largest 100 S&P 500 stocks exceeds that of the remaining 400 stocks in the index.

Your next steps

If you own shares of a mutual fund that mirrors the basket of stocks comprising the S&P 500 Index, your dollars are concentrated on the performance of Apple, JPMorgan Chase, Berkshire Hathaway, Wells Fargo, Gilead Sciences, Verizon, Citigroup and Google/Alphabet, to name a few. What should you do?

1. Double-check your individual investment plan. I have always advised investors to diversify. Diversification calls for investing in a variety of market sectors, a variety of individual stocks, bonds and/or mutual funds and a variety of asset classes. This allows the investment program to fit the individual’s needs and life circumstances. Since the S&P 500 Index has become concentrated of late, now might be a good time to visit a qualified advisor to discuss a possible adjustment in your investment program.

2. Consider doing nothing. In my opinion, the fact that the S&P 500 Index has become concentrated should change nothing fundamental about your financial planning program. Others might advise you to try and time your buying and selling of S&P 500-related mutual funds or stocks associated with the index, but I’d recommend steering clear of making decisions on short-term trends. As I’ve noted before, investors are getting worse at timing their trades.

To show how difficult it can be not only to time markets but to pick individual stocks, consider these fun facts:

  • An equal investment made at the end of the trading day on Dec. 31, 2015, in the 10 worst performing individual stocks within the S&P 500 from calendar year 2015 is up 40.2% YTD through Aug. 31, according to BTN Research. That’s far, far better than the index as a whole. Ask yourself honestly, if someone had suggested investing in the 10 worst stocks from last year, how many people would have embraced that idea?
  • It would have been easy to assume the 10 best stocks from 2015 would be a better investment. But, how have they done so far this year? Through Aug. 31, they’re down 2.3%, BTN Research says. So, you just never know.

3. Don’t compare your investment performance with others. What’s important is making sure that your overall investment program matches your life goals. Investment returns are not the whole picture. Growth in your asset base is important, but likely so is leaving an inheritance to loved ones, using your investments to lower taxes** and having investment liquidity so that you can access funds in emergencies. These later goals have little to do with investment performance.

How is your stock market “orange juice” tasting? The S&P 500 may be somewhat concentrated at the moment. That’s not necessarily a bad thing, but it may be time to chat with your advisor.

* The S&P 500 (Standard & Poor’s 500) is an unmanaged group of securities considered to be representative of the stock market in general. The index cannot be purchased directly by investors. Past performance is no guarantee of future results.

** While our office does not provide tax or legal advice, we have a network of specialists we can recommend to assist with planning.