Pre-Retirees Need To Realize Which S&P 500 They Are Buying

The dominance of bigger stocks is a risk that must be dealt with. Here’s how to do that.

You don’t need me to tell you that when you are putting your hard-earned wealth at risk in the stock market, you need to focus on what you are doing. However, that’s not the type of “concentration” I want to alert you about.

Instead, I’d like to clue you in to something that seems to be separating winners and losers in today’s stock market at an astonishing rate. For those picking individual stocks, the number of sustained winners is small, and getting smaller.

The stock market’s game of chess

It is almost like a game of chess, where you keep losing pawns, rooks and bishops. It gets to the point where the king and queen have little support. And they can’t run around on their own forever.

This is probably one of the most difficult times to be a “stock-picker” that I can remember. And my memory in this business goes back to 1986. That said, maybe you don’t need to be a stock-picker. After all, the markets have changed a lot over the years. There was a time when the romanticism of holding a group of “blue chip” businesses that will pay you a nice dividend and grow their earnings over time was the way to go about investing for retirement.

Meet the new boss, different from the old boss

However, between the earnings shenanigans companies play, the number of established businesses that have suspended their dividend payments, and the way indexing has screwed up the entire concept of “value” investing, is that still realistic? And, with algorithmic trading and hedge funds dominating the buying and selling on a daily basis, the old way of getting things done in the stock market seems miles away.

And, in 2020, a new disruptive element has been added to the mix. Remember when “working the phones” meant you were drumming up sales in your industry, or raising money for a worthy charity? These days, millions of young investors are working the phones in a different way. They are day-trading stocks on Robo-advisor platforms. It’s enough to make a geezer like me look at things differently.

How to adjust

For the foreseeable future, the best way for those approaching retirement (or already in it) can respond to this new landscape is to recognize that it exists. Here are a couple of visuals to help you do just that.

This is the S&P 500. But not the version you see referenced every day. That S&P 500 is 500 stocks, but most of them don’t matter. As of last Friday, the 50 largest of those stocks are more than half the S&P 500’s value. That is, the other 450 account for less of the index’s weight than the 50 biggest. THAT is what investors call a “concentrated” index.

The chart above shows an ETF that tracks that top 50 (symbol XLG). I paired it with another ETF (symbol RSP) that tracks all 500, but each stock is weighted the same. I’ll save you the math, but XLG’s average holding is about 2% of its index, and RSP’s average holding is about 0.2% of its index. So, one is 10 times more “concentrated” than the other.

How did they compare over the past 12 months? The 50 largest stocks returned over 17%. The average S&P 500 stock returned 1.4%. In a mathematical coincidence, the group that was 10 times more concentrated had about 10 times the return.

This relationship has ebbed and flowed over the past several years. The lower part of the chart shows you that. It tracks the 1-year outperformance/underperformance of XLG versus RSP. The current dominance of the largest 50 stocks is higher than it has been, well, for a long time.

Unlike many of the historical patterns I write to you about, this one does not seem to be a market indicator on its own. And THAT is a big deal (pardon the pun). I think the market is telling us that as the 21st Century continues, index investing and ETFs are here to stay. That, in turn, makes stock-picking a lost art that may not find its way out the woods for a while.

That is, unless you think a bit differently. There is still some value to stock-picking, but it has to be done with full understanding that larger companies have the wind at their back. The current healthcare crisis may only strengthen that trend.

If you are going to own individual stocks in this environment, you need to do your homework, and be willing to “own” them instead of “renting” them. In other words, trading individual stocks is a higher-risk proposition than in the past. Expect much more significant zig-zag in individual stock prices over any given 3-6-12 month period.

And, it may be more about separating wheat from chaff among the larger companies, and filling in your portfolio with a more tactical approach using ETFs. That’s been my preferred approach for a while, and I expect it will be even more so going forward.

Alternatively, there is plenty to choose from in the ETF world. And, as long as investors favor the big at the expense of the not-so-big, investment rewards in the stock market may be more about finding good rentals.

I find ETFs are a better way to do that than with most stocks. Because the risk inherent in any stock is much higher than it used to be. That’s how I see it.

As nice as it used to be to drop anchor for a decade and enjoy your group of iconic stocks, this is not the time of life to lose sight of what you are investing for. In other words, this is no time for “style points.”

Related: S&P 500 Looks Healthier Than It Is. How To Diagnose It.