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What Every Investor Should Know About Planning And Saving For Retirement
Like The S&P 500?
This is the 2nd post in a short series that I’m doing all about investor education. So if you watched yesterday’s video, I talked about mutual funds, more specifically, I talked about why many mutual funds fail to beat their underlying benchmark index. I also talked a about a trend that’s been happening for the past 10 years or so where more and more money has been flowing out of these active-based mutual funds and investments into passive index-based investments, either through mutual funds or through ETFs. So what I wanted to do here in today’s video was to talk more about what I think is probably the most popular of these benchmark indexes that people sometimes invest in, The S&P 500.
More specifically, I want to talk about what people are actually owning if they buy into the S&P 500, because I think a lot of people may not fully understand what it is they own if they’re do.
First of all, the S&P 500 is what is referred to as a market-weighted index. And what that means is that the largest stocks within that index, or the stocks with the biggest market capitalization, are going to be where most of the money is going to go within that index. So when we look at the 500 stocks that make up the index, we quickly realize that it’s very top heavy.
If we look at the top three stocks, it accounts for about 10% of all the money that’s in the S&P 500. Currently, those top three stocks are Amazon, Microsoft and Apple. So three technology stocks make up 10% of the portfolio. When we look at the top 10 stocks in the portfolio, it accounts for about 20% of all the money that’s in the S&P. 50 stocks account for about 50% of the S&P 500. And when we get to 150 stocks, we now have about 75% of all the money that’s in the S&P 500 is in just those top 150 names. So you can imagine that when we look at the bottom part of that list, the 350 stocks that are at the bottom, those stocks could be going up a lot, or going down a lot, and they’re still not going to have nearly the kind of impact as the stocks at the top of the list, in terms of what impact that’s going to have on the performance.
One of the reasons why I wanted to illustrate this is first of all, I think a lot of people don’t really understand how that money is distributed, but I also believe that there’s some inherent risks with the way the S&P 500 is modeled here, the fact that so much of that money is going into those top companies.
One of the things I talked about in the last video, was that money is flowing out of active-based mutual funds and flowing into passive investments like the S&P 500. As that happens, anytime somebody adds money to to S&P 500, it gets disproportionally invested in those top stocks, those top 50 stocks, or those top 150 companies. And in my opinion, I think that artificially inflates those prices, and makes some of those prices a little bit unrealistic.
One of the ways that we can tell how expensive a stock is, is to look at something called the price to earnings ratio. Now price to earnings tells us, again, how expensive that stock is relative to how much money it’s going to make, and it’s probably one of the best value measurements that we have out there to determine how expensive a stock is. When we look at those top 10 stocks, just as an example, we learn that those top 10 stocks have a price to earnings ratio of 43. And by historical measures, that’s pretty high, because when we look at the entire basket of 500 stocks, we actually see that the entire basket actually has a price to earnings ratio of just under 18. So those top 10 stocks are trading for over two times the valuation of the basket as a whole. And this is not the first time we’ve seen this. It is something that as more and more money goes into the index, and maybe as more and more money comes out of other investments, it’s artificially inflating those prices, and it’s creating kind of what I refer to as a self-fulfilling prophecy, more money goes into those top stocks, pushing those stocks up a little higher, it entices more people to get into it because they’re seeing the performance of the index, and they’re selling other stocks that may have more reasonable valuations and other factors that may be important.
We’ve seen this a couple of times in history. Probably the most prominent in recent times is in early 2000, right before the tech bubble burst. We saw the S&P 500 balloon up, and about 40% of the S&P was in technology stocks, right before that whole meltdown occurred and technology stocks, obviously, were one of the hardest hit areas of the S&P 500. We also saw it in 2008, right before the worst part of the financial meltdown. We saw the S&P balloon up once again, this time about 40% of the portfolio was in financial stocks, right before the financial meltdown, and the hardest hit area of the S&P was, again, financial stocks. So unfortunately, as this cycle goes, it will continue to balloon up these stocks that are at the top end of the list, and in my opinion, it carries a decent amount of risk, and at some point we may see a bubble bursting here with this as people realize that those stocks at the top are not worth those crazy valuations.
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