Some Fallacies of the S&P 500

This post notes that the S&P 500 wasn’t always capitalization weighted. Until 1988 it was structured much like the Dow Jones Industrial Average but with more companies. There are a lot of thoughts that can spring from that information. One of them is that index investing isn’t really passive investing. It’s true that most active managers don’t beat the S&P 500. But the S&P 500 is a managed portfolio of companies. It was set up and is managed to try to earn higher returns than the other major indexes. A committee at S&P makes regular changes in it. They’ve done a very good job. Perhaps the success of the S&P 500 makes the case for momentum investing, because that’s what a capitalization-weighted index amounts to. There are other thoughts in the piece.

Next, let’s jump to the end of a bull market to see what happens to a cap-weighted index. The results, as the dot-com era showed us, are none too pretty.

When markets go up 30 percent a year, casual investors tend to catch the fever. When this group of unsophisticated buyers all pile into the same well-known mega-cap companies, regardless of valuations, the net result isn’t a surprise — a rapidly inflating bubble.

This is characterized by a self-reinforcing cycle. When we have more buyers of these stocks, it increases the size of their market cap, which sends the S&P 500 higher. At the same time, money managers who are obligated to match the index, send ever-more capital to the shares of the biggest cap companies. This tends to lead naive individual investors to chase the flashy names even more.