For a long time I struggled with indexing for the same reasons anyone does. You're buying expensive companies, the market isn't that efficient, and you're going to buy and hold a lot of losers. In the long run, almost all of the S&P 500's individual holdings will underperform the market as a whole. But here's where I think I went wrong. All those things can be true, but they just aren't that important. Or at least, they're not as important as making sure you own the future winners. That single thing is enough to make up for all the rest, and then some. Owning the S&P 500 is about owning a process, not just a basket of stocks.
The approach of the S&P 500 is pretty elegant. You own more of the largest companies (by market capitalization, and proportionately less of smaller companies. For instance, for every $10,000 you put to work in the S&P 500 today, you'd buy $723 worth of Microsoft stock, $661 of Nvidia, $661 of Apple, $428 of Alphabet (aka Google), $385 of Amazon, and $160 of Berkshire Hathaway. As you can see, as the list continues, the average weighting starts to decline precipitously.
The median company gets a weight of 0.07% (or about $7 per $10,000 invested). Occidental Petroleum and Monster Beverages both have this weighting in the S&P 500. Valued at around $50 Billion, these aren't exactly tiny companies.
This weighting system reflects common sense portfolio construction. You want a strong core of blue chip companies, and these large cap companies fill that role nicely. Everything I've just described outlines the "basket of stocks" aspect of indexing.
But at the same time, companies come and go. The winners of tomorrow might be different companies from the winners of today. Moreover, the stock market has a "winner-type-all" quality, where the vast majority of all gains accrue to a relatively small set of companies. Rather than try to pick which companies will and which companies won't win in the future, indexing says, "let's own everything and make sure that we own tomorrow's winners, whoever they may be."
This may seem like a "throw everything at the wall and see what sticks approach." And it kind of is. But there are two reasons that this isn't completely stupid. One, is that when you're dealing with a winner-take-all system, errors of omission are more costly than errors of commission. That means you lose more by not owning the winners, than you do by owning the losers.
Let me illustrate: If you buy an index fund and Occidental Petroleum or Monster Beverage go out of business, you lose $7. However, if you don't own them at all, and then they grow from a 0.07% weighting to a 2% weighting, you missed out on a lot of profit. The upside is larger than the downside. Thus, diversification at this scale isn't so much about protecting you from losses as it is about capturing gains.
Secondly, the companies you're buying with this "see what sticks" approach have to pass a quality test. To be included in the S&P 500, a company must have a valuation of at least $8 billion, have highly liquid shares, report positive earnings in the most recent quarter, and be net profitable over the trailing 4 quarters. I'm sure there are some relatively speculative companies in the S&P 500, but on average, these are pretty high quality companies. They've reached a point of scale where they are run by professional managers, they have a large enough economic footprint to have some negotiating power in their supply chain, and they have good access to financing. Too, by reaching those valuation and profitability requirements, they demonstrate a viable proof of concept for their business model.
Does this make the S&P 500 the be-all-end-all investment? I don't think so. A big drawback of indexing is that it tends to be somewhat prone to bubbles. Companies are weighted solely by how high their valuation is, not by whether their stock is attractively priced for an investor. So, you're systematically buying more of companies near their peak valuations (at least relative to their own past, and relative to other companies).
Sometimes companies get ahead of their fundamentals and you can end up with a lost decade when the bubbles burst. From 1999 to 2009, stocks had a negative return. This makes the case for including other assets and other investment approaches in your portfolio.
However, buying companies near all time highs isn't always a bad thing, because sometimes a stock will continue to put up good results for many decades. The winners spend a lot of time at or near their all-time-highs.
Returning to the value of indexing, however, my main point is that the mix of companies you're buying in an index fund today are going to be different from the companies you own in the future. Some of today's big companies will stumble, while some of the up-and-comers will up and come. As I see it, the point of indexing is that you own a portfolio that will evolve over time, ensuring that you end up with tomorrow's winners.
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