By Cory Shepherd
As the investing public has gained greater access to information and education about the value of low-cost and diversified approaches to investing, we have turned to index-based approaches in greater and greater numbers. One of the most commonly referenced indexes in the financial media is the S&P 500. In fact, the media use the S&P 500 as a short-cut representation for “the market” so often, the average investor might understandably over-estimate the diversification represented by that single index.
The S&P 500 represents 500 United States based companies that fit the definition of “large cap”, meaning they have a market capitalization over a certain level. Market Capitalization is the number you get when you multiply a company’s current share price by the number of total shares outstanding. If ABC company trades at $100/share and has 10,000,000 shares outstanding, ABC would have a “market cap” of $1 Billion Dollars. Depending on who you ask, the minimum line to be called “large cap” varies, but Microsoft has long had a market cap in the Trillion-dollar range, and the smallest market caps in the S&P have generally been in the $4-$6 Billion range.
How many asset classes are there?
To build a truly diversified portfolio, we need to find access to all the major asset classes that make up “the market”. Depending on how you slice and dice the different categories, we can easily build a list into the teens and beyond. In addition to Large Cap Indexes like the S&P 500, we can find access to US Mid Cap and US Small Cap companies, which all offer different growth and risk opportunities. We can also pull out Growth and Value stock focuses for each of the three size levels, and a Blend category for companies riding the line between Growth and Value. If you are counting along in your head, you can double your number by adding International versions for each of the US based categories. Most investors will benefit from having some portion of their portfolio allocated to bonds as well, which adds at least half a dozen different dimensions if we look at Federal, Municipal, State, Corporate, and International flavors across short, intermediate, and long-term timelines.
Now we can see that the S&P represents one single asset class of many, but how much diversity does it actually give us inside of its own asset class? Over the last 10 years Microsoft, Amazon, Google (now Alphabet), Apple, and Facebook (MAGAF) represented 12.5% of the total rate of return you would have received from being invested in the S&P 500. Out of the list of 500, just 1% of the companies contributed 12.5% of the growth. If we add up the total of all those 500 companies’ market caps, these 5 technology giants represent around 22% of the total capitalization of the S&P 500.
The S&P 500 is a useful index for tracking the relative movement of a certain segment of our economy. That collection of 500 stocks becomes less effective when we use it as a stand-in for a fully diversified portfolio. Whether you manage your own assets or work with an advisor, an annual inventory of asset classes could be well worth your time.
Cory Shepherd CFP®, ChFC® is President of Sound Financial Group, a financial advisory firm and a subscriber to MyPerfectFinancialAdvisor