The S&P 500: cap-weighted or equal-weight?

by | Feb 1, 2024 | Videos

The S&P 500: cap-weighted or equal-weight?

Key Takeaways:

  1. Diversification is key to a smoother investment journey; different types of investments (e.g., mid-caps, small-caps, large-caps, international vs. US) perform differently at various times, helping to mitigate losses in down years and potentially not capturing the full extent of gains in up years.
  2. Market performance varies depending on the index referenced (S&P 500, Dow Jones, Nasdaq), and individual portfolios may not align with these benchmarks, especially if they include a mix of stocks and bonds or different categories of stocks.
  3. The S&P 500’s performance can be misleading as it is a cap-weighted index, where larger companies have a greater impact on returns; an equal-weighted S&P 500 index had significantly lower returns, indicating that a few large-cap stocks drove the majority of the gains.
  4. Investing solely in top-performing large-cap stocks or sectors can lead to a roller-coaster ride of significant drawdowns and recoveries, exemplified by the Nasdaq’s 33% drop in 2002 and subsequent gains in 2023.
  5. Long-term investment strategies that avoid frequent adjustments based on market fluctuations tend to be more effective, as historical average returns account for both up and down years, and consistent allocation allows for compounding over time.

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Transcript for “The S&P 500: cap-weighted or equal-weight?”

Welcome to the Mullooly Asset Show. I’m your co-host today, Tom Mullooly, and this is episode number 369.

Who is that in the other window?

I’m usually behind the camera. This is Tim Mullooly. I haven’t been in front of the camera for a while now, but we’re trying something new here.

So this is the first co-hosted Mullooly Asset Show. We’re running this on a program called Squadcast. They advertise that they do things a little differently than Zoom. Zoom apparently has some kind of lag feature, so it’s good when you’re speaking to a client over Zoom, but not necessarily for recording, or playback on a platform like YouTube or on a website.

Tim, we’ve just wrapped up January of 2024, and people are starting to go through their statements, looking at what the markets did last year. Let’s talk about this.

Sure. And you know, when you use the word “market,” I think it’s important to talk about which market you’re referring to because you could be talking about the S&P 500, the Dow Jones Industrial Average, the Nasdaq.

And depending on which one you’re talking about, 2023 could have looked a lot different, depending on how you were invested.

I agree. And I also want to remind viewers that your account – or your investments – may not be exactly one hundred percent invested in the S&P 500. You may have a portfolio that is, say, 60% in stocks and 40% in bonds. It’s hard to just look at the yardsticks and say, “Why didn’t we see these kinds of results?”

And we get these kinds of questions in years where the year just ended was pretty good. The S&P 500 returned twenty-four percent in 2023. I wish the S&P 500 had returned twenty-three percent because it would be easier to remember — twenty-three percent in ’23. But the S&P 500 did twenty-four percent in 2023.

But that’s not what everybody is going to get.

Yeah, I feel like people sometimes hear that headline number if they’re listening on the radio, or to CNBC, and be like, “Well, I didn’t make twenty-four percent. Why didn’t I make twenty-four percent?”

Right. But, like you said, if you own any sort of fixed income – or you’re not one hundred percent in the stock market, you’re going to have different returns from what the S&P 500 did.

And, if your stock portion of the account isn’t fully invested in the S&P 500, you’re going to have different returns as well. the S&P 500 is just US large-cap stocks. So if you’re invested in any other type of mid-cap stocks, small-cap stocks, growth, value, momentum—any way you slice it up — if you’re not fully one hundred percent in the S&P 500, you’re not going to capture the entire upside or downside in any given year of what that index does.

So that also means that if you called up your advisor or logged into your account in, say, March of 2023 when Silicon Valley Bank was going under and you decided “this was the end of the world” and you put all of your money on the sidelines, in cash, there’s no way that you got these kinds of results.

No, definitely not. I mean, we have numbers here even just to dig inside of the S&P 500 a little bit.

The S\&P 500 is a cap-weighted index, so the larger stocks in the S&P 500 pull more of the returns.

That’s not necessarily the largest price stocks.

Right. It’s the largest capitalized companies, they’re stacked by cap weighting.

So that index was up twenty-four percent, like you mentioned. But if you were to “equal weight” the S&P 500, so every single stock—all five hundred stocks in the S&P—are weighted exactly the same, that index was only up eleven and a half percent. So what that says is that some of these stocks within the cap-weighted S&P 500 were really pulling the ship!

And if you weren’t fully invested in those stocks to those full weightings, you underperformed what that index did.

So you’ll also see that the same names that were pulling the train, so to speak, with the S&P 500 were also pulling the Nasdaq. And so, the next logical question that we get from people is, “Well, hey, if the cap-weighted index includes all of these large-cap names like Amazon, Apple, Microsoft, all of those names, why don’t we just own them — all the time?”

Yeah. And in a year where they’re going up gangbusters, that’s a fair question to ask.

But those same stocks, the ETF that tracks the Nasdaq one hundred stocks, QQQ, that fund was also down thirty-three percent in 2002. And the individual stocks that you’re talking about, some of these huge growth technology companies, if you were to own them individually, you’d have to endure fifty, sixty, seventy percent drawdowns in those bad years — and then hold on to recapture all of the gains that they made in a year like 2023.

So it’s a roller coaster ride. It really is.

Let’s use this in some dollar terms so it’ll help people understand. At the end of 2021, if you had a hundred dollars in the Nasdaq index – or even the S&P 500 cap-weighted index, if the Nasdaq goes down thirty-three percent, your hundred dollars at the end of 2022 is now sixty-seven dollars. If the Nasdaq returns forty percent in the following year, in 2023, your sixty-seven dollars has grown to almost ninety-four dollars. You’re not even back to even.

You haven’t even round-tripped yet.

So that speaks to the benefits of diversification and not putting all of your eggs in one basket. Because sure, you could own just those companies individually, or you could just own the S&P 500 for your stock exposure. But all of these different types of investments—mid-caps, small-caps, large-caps, international versus US—they perform differently at different times, and it can smooth out the ride a little bit.

So in years like 2023, where the market goes up quite a bit, you might not capture one hundred percent of that.
But in years where the S&P 500 or the Nasdaq is going down like in 2022, if you’re diversified in other areas, you might not capture all of that downside as well.

It’s important to know that when historians are talking about the stock market, depending on which yardstick they’re using—over ninety years, over fifty years, whatever yardstick—when they say that “the market has returned nine percent on average per year” or in some cases “ten percent on average per year,” that includes a down year of twenty-five percent. That’s already baked into the cake.

Those numbers are already in there, but you’re never going to get those numbers if you’re hopping in and out of the different baskets and saying, “I want to go to cash because I’m worried about the economy.”

Yeah. It speaks to having an allocation that you can stick with through good times and bad.

So just on a short-term basis, one of the things that we pointed out to clients in the summer of last year, just six months ago, there was a point in time where the Dow Jones Industrial Average, which finished up sixteen percent for the year – was up only one and a half percent.

Yes. So even just within the span of a twelve-month period, if you’re not in at the right times, or you’re trying to time things, you could miss pretty much the entire return for an entire year over the span of a couple of months.

That’s why it’s important to have an allocation that you don’t feel the need to constantly tweak.

Right. You’ve got to let the money that’s going to compound long-term, be left long-term. That really is the answer.

And that’s the message for episode 369.
Thanks as always for tuning in, and we’re going to continue to tinker with this new method of doing videos and podcasts.