Does the S&P 500 Still Provide Diversification?

Does the S&P 500 Still Provide Diversification?

October 20, 2020

One of the first principles of investing is diversification. We are told to spread our bets to decrease risk, which makes intuitive sense and is reflected in the admonition not to put all your eggs in one basket. The S&P 500, an index that represents the 500 largest U.S. companies, is a good example of a diversified investment. Colloquially referred to as “the market,” it consists of stocks in diverse industries such as software, banking, energy production, grocery stores, and pharmaceuticals. Investing in the S&P 500 has traditionally meant an investment in the broad US economy.

This may no longer be the case as the index has become concentrated in a handful of stocks. Apple, Amazon, Facebook, Google, and Microsoft (referred to as FAAMG) now account for 25% of the value of the S&P 500. These five companies, which have been beneficiaries of the Covid Economy (more purchases made at home, greater use of social media, remote work, etc.), represent an unprecedented level of index concentration, surpassing even the era of the late-1990s. Apple, alone, currently represents 7% of the index – the largest single stock weighting since IBM’s 6.4% in 1985. The result is less investment diversification and greater dependence on the prospects of five stocks.

The dramatic earnings growth of the five is the reason they constitute such a large weighting. They have experienced rapid growth while companies more tied to the ups and down of the economy have seen muted – or negative –  earnings growth. Investors have followed the earnings and poured money into these stocks in 2020, culminating in an average gain of 45% year-to-date.

The flipside is that hundreds of companies in sectors like financials, energy, industrials, etc. represent much lower weightings in the index than previously. While the technology sector presently accounts for over 40% of the value of the S&P 500, financials, which consist of banks, insurance companies, asset managers, represent only 9.7%. This is a significant shift from 2007, at the start of the Financial Crisis, when financials represented 22.5% of the index.

There is nothing new in sectors and stocks rotating in and out of favor based on their earnings prospects. What is different this time is the extent of the concentration. The risk is that the unique economic environment supporting these companies’ earnings growth changes and the current tailwinds become headwinds. If the rest of the economy accelerates (the V-shaped economic recovery scenario), interest rates increase, and political winds shift towards treating them as monopolies in need of greater regulation, these stocks could exert significant downward pressure on the S&P 500.

So far, everything is working in favor of the technology sector and the five FAAMG stocks, but it is important to keep an eye on the potential risks and monitor any changes. As 2020 has shown, things can shift quickly.

All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses.  Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved.  Past performance does not guarantee future results.