Episode 6: All Things S&P 500

In this episode of the Life & Finances Together podcast, Roger shares the math behind the S&P 500 index and talks about what to listen for when you hear it mentioned in the news.

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In this episode of the Life and Finances Together podcast our senior financial professional, Roger David peels back the onion of the S&P 500 index to address some of the questions he often receives concerning comparisons and news headlines.

One of the things that we've done a terrible job of in our industry is comparing everything to the S&P 500. As investors, people look at it and assume that what the S&P did equates to what the market did on any given day.

But it’s actually one of the worst representations of what's going on in the overall market. For a number of different reasons, that we’ll talk about.  But we're so conditioned, right? It's what we see every day. It's what gets quoted on TV and on the radio and in different media forms. This is what the market did, and that's directly related to the S&P 500, and a lot of times also the Dow, because that's the one that's been around for the longest period of time. 

But when we look at the S&P 500, it's only a measure of part of the stock market. It's a measure of large cap stocks in the stock market. These big blue-chip companies, these names that have been around forever, that are part of our daily lives.

Another other thing that's really important to understand about the S&P 500 is that it's a cap-weighted index, which means the larger the market cap of the company, the more influence it has on the return performance of the index. Quite simply, it's the number of shares outstanding in the open market multiplied by the share price that gives us a number.  And the larger that number is of that company, the more influence it has on the S&P 500 calculations when we're looking at the performance numbers. So it’s a cap-weighted index. But what’s more, S&P cap-weighted index doesn't get rebalanced. 

The larger these companies keep growing, the more shares they have, the larger or the higher the share price continues to grow, the more influence that they're going to have. There's not a rebalance. There's not an adjustment that's made. 

So you could have a handful or even less than a handful of companies that could dictate the ebb and flow of the S&P index and the calculations and the performance that we see on a daily, weekly, monthly, and an annual basis. So that's really important to understand. 

There is another construct of the S&P 500, and that's the equal-weighted. And, just like it sounds, they take the 503 companies of the S&P 500, tally up their returns, and simply divide by 503. And what does that show? Well, that shows a little bit broader perspective as to what's going on within the index, as opposed to giving this heavier weighting to maybe a handful of companies. 

So the important things to know about the S&P 500 are that there are 2 versions, the equal-weighted, and the more regularly reported on cap-weighted and that it’s just a measure of the large-cap stocks in the United States. Notice that it’s not a look at small-cap and mid-cap and even micro-cap, they call it, all the different sizes of companies within the United States stock market. It's very important to realize what this is actually measuring. 

We hear a lot about the S&P 500 in the news. It gets a lot of attention, and it's hard not to be influenced by what we hear. Why does the media like the S&P so much, and what should we really be listening for when we hear about it? 

When you have maybe a couple handfuls of stocks that are really influencing the ebb and flow of the index on a daily basis, and even on a weekly, monthly, and annual basis, it sells ratings, it sells advertising. It keeps you glued to the set because it's swinging so much. But when you look at this, you have to understand what you're looking at. That's one of the reasons why the media loves quoting the S&P, because it swings more. And the ebb and flow is going to be much greater than the equal weighted. 

And one of the reasons is that when we look at this cap weighted index, what we need to understand is that 10 stocks out of 503 stocks in the S&P 500 represent 34.35% of the index. 

Because we're giving heavier weighting to the larger companies in the S&P 500. Where those 10 companies go, a lot of days, is where the index goes. There's even been times when one or two of these 10 largest stocks have created a result that was positive when the rest of the index, or at least the lion's share of the index, was negative on that certain day. 

That’s a pretty big influence. So when we look at this and say, wow, 10 stocks represent 34.35% of the return. When we look at this in portfolio construction, odds are you're not going to put 34.35% of your portfolio into 10 stocks. 

So why are you looking at the S&P 500 and thinking that's the best benchmark for you to compare your performance against? We're not going to do that as far as our portfolio construction for our clients. 

When we look at this, what's incredible about this, and this illustrates the lack of rebalance on the S&P 500. Going back to 2018, the 10 largest stocks on the S&P 500 index represented just a little bit more than 20% of the index. 

Now, the 10 largest stocks represent 34.35% of the index. These companies just keep on growing. The share price keeps going up, and we keep getting this larger and larger cap weighted value on these different stocks. 

Isn't that incredible? 

In 2022, the cap weighted index, because we had this influence with these 10 largest companies that represent over 30% of its return, was down almost 19.5%. But the equal weighted was down just a little bit north of 12%. So again, not only can it help when things are going up, but it can also hurt when things are going down. Understand, you'll look at this and say, well, gosh, the S&P was down almost 20% in 2022. Well, was it? 

Why is that important? Because it's going to affect your decision-making. It's going to affect your emotional response to this. Maybe if the market's down 20 versus the market being down maybe a little bit north of 12, you're going to look at it and say, okay, 12 is within my risk tolerance level. It's within the range that I can accept fluctuations within my stock portfolio. Well, you need to look at that a little bit closer and have that understanding. And I guess I'd throw it out there and say, stop comparing yourself to the S&P 500. 

You should have a composite benchmark that you put together along with your advisor that does what? That mirrors what your portfolio is doing. We're always going to go back to this thing called risk-adjusted return. That's what you need to be looking at. And if you're unhappy with where your portfolio is based upon the risk that you're taking, you're going to have to make some adjustments. 

I always like to tell clients, when you're listening to the media, you're watching TV, you're listening to the radio, the one thing that I stress the most, pay attention. Pay attention; understand what they're saying. They're going to give you sound bites. They're going to give you words that get you excited. They're going to give you words that are going to get you scared. 

I love the one they use all the time where they're saying, the market's at an all-time high. Well, if you're not paying attention, and you might hear that in passing, whether in your home or in your car or watching TV, what do you think? You probably think the market's up 20 to 30 percent. Well, you have to have that point of reference. 

Where was it on the previous high? They've been quoting that here in 2024. Oh my gosh, the market hit a new high! It's at an all-time high. Well, understand, with a lot of those reports that happened maybe in the spring of this year, the previous high was on January 3rd of 2022. So if you go just a tenth of one percent above January 3rd of 2022, guess what? You're an all-time high. 

And great, we're recovery, but are you any farther along? Is your portfolio any farther along than what it was on January 3rd? I'll tell you what, for most people, it wasn't. 

So when we hear about the S&P in the news, and when it gets a lot of attention, whether it's positive or negative, how should we react and what should we remember about this index? 

Going back to what we had said before, this is really a measure of large-cap stocks. Now in most portfolios, that is the larger component of the stock portion of the portfolio. But remember, you also have international stocks, maybe some emerging markets overseas. Maybe you're going to have some small and what we call small and mid-cap stocks here in the United States, which are basically just smaller companies. They're not as big as a General Motors or a Procter & Gamble. They're just smaller companies. 

And everybody in a diversified portfolio, if you're doing what you should be doing, has exposure to these different stocks, these different sizes of stocks. And especially exposure overseas, developed international like Europe and Japan, as well as emerging markets like China, Russia, Brazil, India. If you're diversified, and you put together a good portfolio that's staying diversified by representing all kinds of different sectors and different areas of the world, you're not just going to have large-cap stocks that are represented by the S&P 500 in the portfolio. And one other component too, and regardless of what your age is, the amount varies, you're probably going to have some fixed income or very simply, we're going to have some bonds in the portfolio. 

Now the younger you are, you usually have fewer bonds - less bond exposure. The older you are, you're producing income. You're retired. You need your assets to produce income. Maybe you're going to have a larger portion of bonds. So this is another important component to remember. 

Whatever you're doing, whatever life stage that you're in, comparing yourself just straight up to the S&P 500 and even the Dow Jones Industrial Average, you're really doing yourself a disservice. And you're going to be disappointed. You're going to be disappointed more than you're going to be happy because in most cases, you're not performing at the level that the S&P is. 

And any advisor that's advising you, if you're really managing your money in a responsible way, is not going to put all your eggs in one basket and just load up on the stock market and say, hey, don't worry. The market over time goes up.

Well, nobody has a timetable of 100 years or 50 years. And we're kind of even pushing it for 30 years where you can just say ramp up on the stocks. I'll worry about diversification later. Nobody has that long of a timeline. 

So this S&P 500, it's a good gauge to see if markets are going up and down. But it's not the full gauge of the entire market. There are other indices that do a little bit better job than that, which you don't get quoted on. Why? Because maybe they don't swing as much. They're not as exciting. They're not as familiar, right? 

What you need to do though when we look at this is pay attention, number one.

Number two, make sure that you understand what's the level of risk that you're taking, right? Are you a 50% stock, 50% bond portfolio? Well, if you're expecting returns that mirror the S&P 500 and you're kind of a middle of the road portfolio as it relates to risk, you're going to be disappointed a lot. When things go bad and the market goes down and you're looking at what's happened, well, the opposite could be true. You're taking less risk. The drop in value of your portfolio in most cases will be less. So just make sure you're paying attention. 

And probably the last thing that I would stress is go back to your financial plan. Your plan is your benchmark. The assumptions in your plan are what your benchmark is based. 

If you did your job and you saved your pennies the way you were supposed to throughout 30 years of work, that means you can probably weather some fluctuations. You can weather some storms. You did your job. You didn't save just enough. So you always want to go back and say, look, I know what I've saved. I know what I have. Do I need to take more risk than what I'm taking? 

We always go back to clients and say, look, when we did your plan, the level of risk you're taking may be equated to, let's say, a rate of return of 5.5 or 6%. And then what do you do? You talk to your neighbor over the fence who happens to be 20 years younger than you. New to the neighborhood, young family, right? And all of a sudden, they're telling you what they're doing. And you get excited. And you want to start doing what they're doing. That's not your plan. 

And you need to understand the level of risk you're taking, and you need to understand what the impact could be to your plan, to that benchmark that we're always going to go back to. It's you. It's not this index. 

It's not the general market, right? It's definitely not what your neighbor's doing. You need to make sure that you understand that and make appropriate adjustments. I'm not saying that you can't change what you want to do, that you can't change maybe your risk tolerance. 

Things change. People change. Your mentality, your approach toward things, your view of things may change. But before you make that change, understand what that impact could be to your financial plan, both near-term and especially long-term. 

That's the thing you need to look at. Not just one simple index that gets quoted in the media every single day as you're passing by the TV or listening in your car. 

If you ever have any questions, maybe you're concerned about some things that are going on in the market or the economy, don't ever hesitate to give us a call. 

Because we’re going to do the math. We're going to sit down. We're going to take a look at whatever's happened in the markets of the economy and see what the impact has been on your financial plan. And when we sit down and do this. When we actually do the math, you know what the response is many times when clients are walking out the door. I can't say it's every time, but most times is, Rog, that wasn't as bad as I thought it was going to be. And you know what? I'm really glad that we did the math on this thing to see what the impact was. Now I can go home and sleep. Now I'm not going to be worrying about it because I'm not thinking about different scenarios in my head that aren't relevant to me. I'm thinking about things that I looked at that are part of my financial plan.

So don't ever hesitate to give us a call. Do the math with us. We're happy to do it. It's what we love to do. 

Thanks so much for reading, watching, listening, and for learning more about the S&P 500 Index with us today. If you have any questions about our team, our services, or finances in general, please check out our website, rinveltdavid.com. Send us an email, give us a call, and of course, please like and subscribe to our podcast and stay tuned for the next episode.