The Illusion of Indexing

Dec 2017 //
Investing
Di-worse-ification

It may seem comforting to invest in an index with 100 or 500 component companies. However, appearances can be deceiving. For example, the S&P 500 contains 500 companies, so the top 50 companies and the bottom 50 each represent 10% of the index’s total companies. However, the top 50 account for approximately 49% of the index’s weight, and the bottom 50 account for only about 1%. As a result, the effective diversification within the S&P 500 is much less than some might imagine. Similarly, the Nasdaq 100 index is heavily weighted in just a handful of companies. The top five amount to roughly 40% of the index’s total weight. As a result, in any given day, week, month or year it is not inconceivable for this index to move the opposite way from the majority of its component companies.