How to Invest in a Top-Heavy Stock Market

Investing is an endeavor to help you grow your money without you having to be the one putting in the work to make it grow. The amount you are likely to accumulate is based on three main factors: 1. How much you are able to contribute. 2. How long can you allow the money to work. 3. What type of return will you make on your investment. The first two factors are ones that you have more control over than the third. However, the return on investment is often what people focus on more than anything else. That may be because that is where a lot of media attention is placed or because it is easier to compare your investment returns to someone else’s. It is important when looking at investment returns to have the proper context because all investment returns, and investments for that matter, are not created equal. In these times where people do much of their investing in an employer plan or utilize “passive” investment strategies to grow their investment portfolios, it is really important to have context to understand what is happening with your investments and to act accordingly. If you have, for example, chosen to invest in funds mirroring the S&P 500 index to get broad exposure to the U.S. stock market, you may have been pretty pleased with your investment performance in the first half of the year. Unless you have been paying close attention, what may be less obvious, though, is that the lion’s share of that positive performance was based on the growth of a small number of the stocks that make up the S&P 500. While you may not care where the performance came from, the fact that a small number of stocks drove that performance, means that should those stocks stop performing as well, there could be an impact on the growth of your portfolio as a result. So, in this issue of the newsletter, we will discuss how you may want to approach your investments in a market such as what we are in now.

What Does It Mean to be in a Top-Heavy Market
To be clear, when you hear discussion about the stock market, for example in the financial report on television, they don’t report on the entire stock market What is used is indexes that essentially give you a sample of the stock market based on a group of stocks. Stock indexes are comprised of a group of stocks that represent a sector, stock exchange, or economy, and they are intended to indicate how stocks, and thus the performance of the companies they are sampling, are trending. Decades ago, when manufacturing was king, the index you would have heard reported on was the Dow Jones Industrial Index, but today the index that gets the most attention and is considered the most representative is the Standard & Poors 500 index (S&P 500), which includes 500 of the largest companies in the U.S. The goal is for investors to be able to gauge how a sector or the economy at large is trending based on the changes in the index because an increase in the index means the stock prices of the companies in the index have increased. However, the organization that creates the index determines its own approach to how it builds the index. Two of the common ways indexes are built are equal weighted and market cap weighted. An equal weighted index starts with the same percentage of weight to every stock contained in the index. For example, if the index contained 50 stocks, the value of each stock would start out representing 2% of the index. Of course, as time goes on and the share prices of the stocks change, the balance would change such that the equal weighting does not remain. A market cap weighted index considers the total valuation of each company whose stock is part of the index and gives greater weight proportionately to those companies who have higher valuations, meaning a very large company (e.g. Amazon) makes up a larger percentage of the index. This is where the top heaviness of the market comes into play. The S&P 500, which is typically considered the indicator of the performance of the U.S. stock market, is a cap weighted index. As of early August, the top 5 companies in the S&P 500 comprise more than 25% of the value of the index. In other words, 1/100th of the companies made up more than 1/4th of the movement in the index. Perhaps not surprisingly, the top companies in the S&P 500 are technology-based businesses. What perhaps is surprising is that Google, as big and influential as they are, is just outside of that top 5. To be fair, Google has two classes of stock that happen to be in positions 6 and 7, so if you combined those two share classes, they would fall inside the top 5. If you extend to the top 10 companies, they comprise more than 1/3rd of the value of the index. The impact of the fact that a relatively small number of companies have such an outsized influence on the movement of the index is that you may have unrealistic expectations of your own investment portfolio if you expect it to perform like “The Market”. Unless your portfolio is made up of investments that are the same as whatever index you are tracking, your performance very well could look different than that of the market at large.

The Risks and Rewards of a Top-Heavy Market
The concerns raised about a market that is top-heavy are the outsized influence a small number of companies have on its performance. The implication is that if you see strong growth in an index, like the growth the S&P 500 has experienced since late 2023, it could be that the move in the index is only representative of a few companies doing well. You may have heard the term “The Magnificent Seven” in reference to the stock market. That reference is for the largest 7 stocks in the S&P 500: Apple, Microsoft, Alphabet (parent company of Google), Amazon, Nvidia, Meta (parent company of Facebook) and Tesla. All of these companies are technology driven companies and have benefitted from the advance of Artificial Intelligence (AI). The growth of the Magnificent Seven stocks in the first half of 2024 was 31%, whereas the whole index was up 14.5%. The other 493 stocks in the S&P 500 were up 7.4%. With a small portion (less than 2%) of the index driving the growth of the index, the question becomes whether strong performance by the index means a healthy market or simply a few healthy companies. That represents the risk, taking good performance of an index that may not be broadly performing that way and extrapolating that to performance of the stock market at large. More importantly, for individual investors, what is important to understand is how your own portfolio is likely to perform rather than what the overall market or an index is doing. If you have invested in such a way that your portfolio mirrors the index, you can expect to see similar performance, for good or bad, but it is likely that your portfolio does not specifically correlate to a particular index. However, if for example, your portfolio was largely invested in the S&P 500 or even invested largely in the technology stocks that have been doing so well, you would be benefitting from that top-heavy market. Therefore, a top-heavy market is not necessarily a good or bad thing for you as an investor. What is more important is how your portfolio is constructed, which we will discuss next.

Determining Your Investment Approach
Make no mistake, you can alter your investment portfolio to position it to benefit from whatever direction a top-heavy stock market moves in, but unless you have more information than everyone else, those adjustments may be as much guesswork as anything else. As boring as it may seem, the prudent approach for most people is not to try and make a bet on how the market will behave based on the concentration of certain stocks at the top of the market, but instead it is to use smart investing principles that apply regardless of the market conditions. In other words, if you have a fairly lengthy timeline before you will need to tap into your investment, it probably is worth your while to maintain your normal posture, assuming you have set your portfolio up strategically in line with your objectives. If your timeline is extremely long, might you want to consider taking a little more risk by perhaps allocating some additional money towards specific investments or sectors that you believe have a chance to benefit from the current environment? That is always a consideration if you have plenty of time ahead of you, but it is often wise to not “bet the farm” but instead to take a smaller portion of your portfolio to take that kind of shot. On the other hand, if your timeline isn’t nearly as long, and you expect you will need access to your investment proceeds sooner, it may be a good idea to take some of your investments out of the stock market to minimize the potential for wide fluctuations in the value of your portfolio. When it comes down to it, whether the stock market is top-heavy or evenly distributed, in the long run, the stock market has historically performed extremely well. In the short run, the stock market is subject to periods of higher volatility that can impact not only the movement of the indexes but your own investments. Not that what has happened before tells us what will happen in the future, but leaning on historical context and the long-term trends of the stock market has tended to make for sound decision making and is more likely to help you achieve the outcome you desire.

Stewardship Emphasis

Trends like fads come and go. Sticking to tried and true principles instead of latching onto the latest thing can be a better formula for success.

The Empowerment Channel    |   Volume CCXXVIII   |    Dedicated to Promoting Financial Education through Stewardship