Updated 2/15/22
Whether you are a newcomer or a seasoned investor, odds are you have heard the phrase “index funds” when it comes to investing for retirement. Today, we’d like to look “under the hood” of the stock market to find why there seems to be such a consistent bias to the upside for the major indices throughout history. While many will point to the diversification of the major indices, there is another aspect that we believe has an equal-if-not-greater impact on this upside bias: survivorship bias.
Of the three major indices, both the S&P 500 and the Nasdaq-100 are what is known as cap-weighted indices. As a refresher, a cap-weighted index determines a stock’s weight by multiplying its current share price by the number of shares outstanding; in short, the more a stock’s price increases, the greater the weight a stock will have in the index.
While this seems straightforward, not every index follows this methodology, most notably the price-weighted Dow Jones Industrial Average. Through cap-weighting, both the S&P 500 and Nasdaq-100 follow a process that resembles a momentum strategy: let your winners run and cut your losers quick.
For example, if the next Amazon appears, cap-weighted indices will allow that new company to gradually increase its weight in the index through its improving stock price. On the flip side, if a company is past its prime and on the decline, a cap-weighted index will allow these outdated companies to shrink and fall out of the index.
One way to better understand this phenomenon is to compare where the S&P 500 stands today versus its history. In 1972, the S&P 500 contained 157 companies that fell under the industrials sector; consumer discretionary, consumer staples, energy, and utilities rounded out the rest of the top five sectors in terms of the number of companies within the index.
On the flip side, there were only 15 technology stocks within the index. In the following 50 years, however, there has been rapid change and innovation. Today, the technology sector leads the S&P 500 with 73 companies, while the industrial, financial, healthcare, and consumer discretionary sectors round out the top five sectors.
In fact, the number of industrial stocks in the S&P 500 has fallen from 157 to 72 since 1972, while the healthcare sector has increased from 20 stocks in 1972 to 65 stocks today.
The technology and healthcare sectors have seen some of if not the most innovation in the past 50 years, and cap-weighted indices such as the S&P 500 and Nasdaq-100 were uniquely capable of taking advantage of that innovation.
In short, cap-weighted indices such as the S&P 500 and Nasdaq-100 follow the momentum of economic innovation. When companies become mature or obsolete, their share price suffers, which in turn decreases its weight in the index and potentially causes it to be removed from the index entirely.
On the other hand, innovative companies such as the megacap tech companies were allowed to grow and thrive in the index, to the point where they now make up over a fifth of the S&P 500 and roughly 40% of the Nasdaq-100. Through this momentum aspect, we hope investors can now see an additional reason for why the major indices have historically had a bias to the upside.
Securities and advisory services offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC. Additional Financial planning may be offered through Chairvolotti Financial, a registered investment advisor and a separate entity from LPL Financial.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. All investing involves risk including loss of principal. No strategy assures success or protects against loss. The economic forecasts set forth in this material may not develop as predicted.
