Diversification is a key piece of a portfolio that is looking to control risk. Investopedia describes diversification as follows: “A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.” How diversified are many of our major investment indices?
iShares MSCI ACWI ETF tracks a market-cap-weighted index of large and midcap global stocks, covering 85% of the developed and emerging markets capitalization. Market capitalization is a measure of the size of a stock. The global index ETF has 2,266 holdings. Three stocks make up more than 8.5% of the index: Apple, Microsoft Corporation and Amazon. All other stocks make up 0.04% of the remaining portion, on average. It may be said that diversification is not as strong as one might think.
Major news networks commonly display stock market performance for three major indices: The Standard & Poor’s 500 Index, Dow Jones Industrial Average and NASDAQ. These indices all primarily represent large companies in the United States. They are very similar in many respects.
All of these indices are “market cap weighted.” This means that each stock in the index represents a portion of ownership in relation to the size of the company. In other words, larger companies contribute more to the performance of the index than smaller components. Over the past 10 years much has been written about the large influence of specific technology stocks on the performance of these weighted indices. This phenomenon is alive and well today. It is important to recognize the impact of these large technology companies on the performance of these common indices.
Year-to-Date through July 7, 2020, Amazon, Microsoft and Apple have dominated market performance, up 62%, 33% and 28% respectively. It stands to reason that these technology stocks have done well in the face of the COVID-19 epidemic, as we all leaned on technology more than ever during this time of remote learning, work and shopping. Conversely, the S&P 500 index is down 2.55% through July 7, 2020. This means that the other 504 stocks that make up the index have not performed nearly as well as these three specific stocks.
In some ways, it seems that the stock market as indicated by the S&P 500 may be ahead of itself, having almost recovered to past highs after a sharp and quick bear market. However, as we peal back the layers, we realize that not all areas have recovered the same. While some areas, such as technology, have reaped the benefits of quarantine, other areas have not fared as well.
There may be some volatility yet to come in S&P 500 performance as we move into election season. However, despite index performance that may seem ahead of actual economic data, I believe this lack of diversified performance indicates that we may be able to see a less wild ride with the overall index. Significant swings within the sectors that make up the index, however, are likely.
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