But who walks into a store and asks to buy the most expensive items?
A number of companies have recently become newly minted members of the trillion-dollar market capitalization club. Market capitalization is the value of a company, calculated by multiplying the number of shares it has issued by the current stock price.
Apple and Microsoft are firmly entrenched in this category, while Amazon and Alphabet (Google) are hovering at or just below a trillion-dollar market cap depending on the day. When you invest in a market-weighted S&P 500 fund, which is the most popular way to invest in the index, your money is allocated to 500 of the largest publicly traded companies, based upon their market value relative to the size of other companies.
For example, Apple currently makes up approximately 4.8 percent of the index’s value, which means 4.8 percent of your investment is allocated to Apple, which had a 12-month return of almost 90 percent. After Apple, the companies with the highest weights are Microsoft, Alphabet, Amazon and Facebook as of February 2020. These five companies, either in or closely related to the technology sector, account for 18 percent of the S&P 500 index.
Certainly, investing in the S&P 500 has delivered excellent returns over the last 11 years. After such a sustained run of growth, you may ask, “What could possibly go wrong with this strategy?” The answer is, unfortunately, “a few things.”
First, valuation levels are quite lofty. By investing in a market capitalization index, we are often agreeing to allocate significant amounts of money to the most expensive publicly traded stocks. But who walks into a store and asks to buy the most expensive items?
Second, sector concentration is a potential problem. As mentioned above, the five largest companies in the index are all strongly correlated to technology. Therefore, investing in the S&P means placing a big bet that the technology sector will continue to produce the strongest returns in the stock market.
Third, index investing is an extremely crowded space. Due to their immense popularity, index funds are used by many individuals, 401(k) plans, pension plans, endowments, and so on, as a primary equity investment strategy. As we witnessed in the fourth quarter of 2018, when the market fell 20 percent, everyone rushed to the exit at once, exacerbating the decline.
Fourth, and last but not least, we have seen similar scenarios painfully unravel before. In the 1960s, a popular investment strategy was termed the Nifty Fifty. In theory, all an investor had to do was buy and hold the most popular companies at the time. These included the likes of Digital Equipment, Eastman Kodak, General Electric, Polaroid and Joseph Schlitz Brewing, even though they were trading at alarmingly high valuations. This strategy backfired when the 1973–74 stock market crash led to a bear market that lasted many years.
What is an investor to do, given this set of circumstances? We would not entirely abandon market capitalization indexing but would look at reducing our allocation. There are a number of other indexing strategies to consider, including equal weighting and fundamental indexing.
Equal weighting simply allocates each of the 500 companies a 0.2 percent portion of the investment. Fundamental or quantitative indexing requires some active decision making, where companies determined to be overvalued are assigned a lesser weight relative to their undervalued counterparts.
We often prefer to use individual stocks, which have not participated as significantly in the bull market rally, as a way to diversify. The healthcare and financial services sectors presently offer some attractive opportunities, in our opinion, as their performance has lagged the overall market. Option strategies can also be employed to hedge against market pullbacks.
When faced with extraordinary market conditions, having a disciplined asset allocation strategy remains paramount. After an exceptional year of returns, investors have to recognize that their equity allocation has likely increased dramatically, necessitating a rebalancing of their portfolio and a reevaluation of their approach.