The S&P 500 Cheats (and so should you)!

How a market-cap-weighted index "rides the winners."

Imagine an "investment" that costs $92 and is made before the start of the NFL season. Your task is to choose 8 teams you think will have the highest combined win total during the regular season. You earn a dollar for each of the combined number of wins for your chosen 8 teams. You can then compare this total to your $92 initial investment to see if you made or lost money. There are 32 teams in the league, and each team plays 17 games.

If you consider yourself a football expert, you could choose the teams yourself. If not, there are plenty of football “gurus” talking on TV or posting their predictions of the best teams. Or, you could pay an "expert" to pick the teams for you.

The Division Winners Index

There's one final option—the Division Winners Index that automatically ends up with the combined wins of the 8 division winners.

Do you go with the Index, or do you try to "beat it?"

Beating the Index is possible, because sometimes a team wins their division with fewer wins than a 2nd place team in another division. For example, in 2022, the Tampa Bay Buccaneers won the NFC South with 8 wins while the Dallas Cowboys finished 2nd in the NFL East with 12 wins.

So, it's possible to beat the Index, but not likely.

Now, what's your choice?

If you're wondering, the 2024 Index had 99 wins (or $99), which is a 7.6% return (or about 15.8% on an annualized basis) on a $92 initial investment.

By comparison, the 2023 Index had 90 wins, a -2.2% loss (-4.4% annualized).

The S&P 500

It's not a perfect analogy, but beating our fictional Division Winners Index is a bit like trying to choose a portfolio of stocks with the hopes of having a higher return than the S&P 500 Index.

Sure, it's possible, but it's difficult.

Why?

Because the Index cheats!

OK, it's not exactly cheating. It's a byproduct of how the Index is created.

The S&P 500 is a market-cap-weighted index, meaning that the largest companies by market cap (stock price times outstanding shares) make up a greater portion of the index.

As of May 15, 2015, the Top 10 stocks in the S&P 500 Index were:

These 10 companies make up a whopping 38% of the Index.

The top 20 companies make up 47% of the Index—nearly half.

Some view this as a disadvantage, arguing that the Index, by being concentrated in a small number of stocks, is not sufficiently diversified.

We would argue that many investors are too diversified (Warren Buffett certainly isn’t).

To use our football analogy, it would be the equivalent of owning all the teams instead of the 8 division winners.

Riding the Winners

Basically, what happens is that the companies that prove their ability to find ways to consistently make money over time grow in market value and rise toward the top.

This doesn't imply that these companies are perfect, but they tend to find ways to adapt to the current environment.

Companies that fail to be successful become progressively smaller and are a smaller drag on the Index performance.

In the same way that a younger, rising star may take the place of an older player with declining skills, a company that proves more successful in adapting to the current environment can surpass a company struggling to do so.

Most importantly, this happens automatically.

You may not have thought of Nvidia as a rising star back in 2001 when it was added to the S&P 500 Index, but it briefly became the largest company in the Index and is currently number 3 behind Microsoft and Apple.

The important point is, if you owned the S&P 500 at the time, you were in on Nvidia from the beginning. Other companies competing in the same space didn’t make it. You didn’t have to guess.

With a market-cap-weighted index, you automatically “ride the winners.”

How Have the Pros Fared?

Given the unfair advantage built into the Index, it’s fair to ask how the pros have fared when trying to beat it.

Would you expect the experts to be able to win consistently?

To find out, we looked at data published by S&P on a semi-annual basis showing the percentage of large-cap mutual funds that beat the index for various time periods.

Here are the results as of December 31, 2024:

1 year: 35% of All Large-Cap funds beat the S&P 500 Index.

3 years: 15% beat the Index.

5 years: 24% beat the Index.

10 years: 16% beat the Index.

15 years: 11% beat the Index.

Looking at these numbers, it makes you wonder why anyone—expert or not—would try to beat an Index with such an unfair advantage.

Fortunately, you can now easily invest in the S&P 500 or any other market-cap-weighted index, through index funds or exchange-traded funds. Some of these options are almost certainly in your 401(k) account.

Of course, if you enjoy the process of building a portfolio of individual stocks, you can certainly do so. The point is, you don’t need to if all you care about is growing wealth over time.

Best regards,

Stuart & Sharon