The S&P 500 OR the S&P 5?
The S&P 500 is intended to be an index of 500 large companies listed on stock exchanges in the United States. However, if you take a closer look, you’ll find that just 10 stocks—or 2 percent of the total 500—account for almost one-third of the index’s overall performance. Why does this happen, and why should you care? Let’s take a closer look.
The S&P 500 is a Weighted Average
At first glance, it may seem like the S&P is an equal representation of 500 different stocks, but that’s not how it works. The index is actually a weighted average, so larger companies drive a more significant proportion of the index’s performance than relatively smaller companies. As the largest companies continue to grow ever larger, the market is becoming increasingly concentrated. This causes a dramatic lack of diversification, which can be financially catastrophic.
1999 was the last time we saw statistics similar to this. At the height of the dot-com bubble, excessive investments in Internet-related companies led to an inflated market rise. In March 2000, the NASDAQ Composite rose 400 percent, only to fall 78 percent—or $5 trillion—by October 2002, negating all the gains experienced during the bubble. The dot-com crash also caused countless Internet startups to fail.
How to Ensure Portfolio Diversification
The issue of poor diversification lurks beneath the surface of many portfolios, particularly these days, given the massive run-up of a small handful of companies driving a disproportionately high segment of the market. The media has labeled these companies the “FANGs” because they comprise Facebook, Amazon, Netflix, and Google, among others.
Clearly, when it comes to diversifying your portfolio, it’s not enough merely to own index funds. You really need to dig deeper and see what percentage of your portfolio is constituted in your top 10 holdings, which shows you what you ultimately own.
With the way things are right now, index funds may be comprised of the same kinds of companies. Remember, the top 10 holdings in any portfolio should never exceed about 20 percent of the portfolio’s total value. And if your top 10 holdings begin to exceed 30 percent, your portfolio is not nearly as diversified as it should be.
To sum up, it’s vitally important to be aware of the impact of investing in the S&P. If you’re not careful, you could end up with a serious lack of diversification, even when you think you’re diversifying effectively by investing in an index fund. For help digging into your portfolio and optimizing your investments, please contact Nelson Financial Planning. We’ll help you change your life with a successful financial plan.
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