Time to check your diversification
With the steady rise of tech stocks over the past few years, there has been a growing disconnect between the notion that an index fund is a “diversified basket of stocks” and the reality that the fund may hold a small number of stocks that represent a high percentage of the fund’s value. This problem has led some index fund providers to formally warn shareholders that they are no longer “diversified.” If you’re not familiar with how most index funds are structured, they are designed to be “capitalization-weighted,” meaning the companies with the largest capitalization (# of shares x price) will be owned in the largest percentages by the fund. While capitalization is influenced by company revenue and profitability, it is also significantly influenced by the market “price” of the stock, which may have been pushed higher by speculation, as is the case today with large tech and AI-focused companies.
This lack of diversification today stems from the fact that the top 10 stocks in the S&P 500 now make up 38.5% of the index (or 33.7% of the Total Stock Market Index), more than the next 100 stocks combined. In fact, the first 25 stocks in the index account for more than half of the index’s value. Put another way, 25 stocks = 51.5% and 475 stocks = 48.5%, a very lopsided example of diversification. The top 25 have an average Price/Earnings ratio of 56.8, more than 3 times the historical average, while the P/E of the bottom 25 is 32.3, about twice the historical average. To be clear, the top stocks will likely always have above-average valuations because that’s how they got to be at the top.
An index fund like the S&P 500 will include stocks from the 11 sectors, including energy, financials, and industrial, but because it ranks stocks by valuation, it will concentrate fund ownership in the largest U.S. companies regardless of sector. Only 1 stock in the top ten today is not a tech stock. But ranking by size creates another problem. In some sectors, companies are by nature smaller. In the industrial sector, Caterpillar Inc. is the 2nd largest company, but it’s 32nd in the S&P 500. In the Materials sector, Linde Plc is the top stock, but in the S&P 500 it is 48th.
There are pros and cons to an index being lopsided or non-diversified. Over the past 10 years, the S&P 500 returned 14.7% annually, reaching a point of “non-diversification,” while an “equal-weight” S&P 500 index fund returned only 11.5%, a significant difference. But if the top 10 tech stocks drop significantly in price, bringing them back to more normal valuations and thus allocations, the capitalization-weighted S&P 500 index would fall more than the equal-weight S&P 500 index. Simply put, the index’s recent high returns were driven by the top 10, not the bottom 10 stocks.
This non-diversification problem extends to some Target Date Retirement funds that use a Total Stock Market Index fund because the top 10 of the “total market” 3,500 stocks make up 33.7% of their holdings, almost the same as the S&P 500. Fortunately, many of these Target Date funds include international stock index funds, slightly increasing diversification. Other Target Date funds will lessen the diversification problem by mixing a number of specific index funds for growth, value, and even small-cap stocks.
So, why is diversification so important? Diversification lowers volatility and reduces investment risk because a bankruptcy or a downturn in one sector of the economy is mitigated by owning many more profitable businesses across all sectors of the economy. We tend to forget that over the long term, 10 years or longer, the fortunes of even the largest companies can change significantly. GE was one of the premier and largest U.S. companies decades ago, but today it exists only as a few much smaller separate businesses in aerospace, health, and wind energy. For decades, Apple was only a computer company, then came the iPod, iPhone, iPad, etc., pushing it to one of the top 5 largest companies. Wide diversification protects you from the fortunes and misfortunes of many companies over the long term.
If your portfolio is 80% S&P 500 index and 20% a Total Bond fund, consider options to increase diversification. You could split the 80% stock allocation into 4 funds: S&P 500 Index, Value Index, Small Cap Index, and International Index. Allocate evenly, or use smaller allocations (5% to 10%) to the Small Cap and International funds. A downturn in the top 10 stocks now has much less impact. While a majority of the Value Index stocks are also in the S&P 500, adding that fund increases the percentage of more reasonably priced S&P 500 stock holdings. You’re essentially diluting the percentage of the top stock holding in the total portfolio. Again, adding several funds of different sizes or sectors will dilute the impact of the top 10 stocks.
In summary, you must check your portfolio’s diversification because your account or fund provider will not. Under each fund’s “portfolio composition” or “holdings” tab, you’ll find the number of stocks and their percentages, which you can use to judge whether it’s too concentrated at the top. As described above, you can improve diversification through more thoughtful fund selection. Once done, you’ll feel better knowing you’ve corrected the current poor diversification caused by tech stocks in capitalization-weighted index funds.
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