The S&P 500 is Less Diverse Than It Used to Be. Here’s Why That Matters.

Many investors hold S&P 500 index funds in their portfolios, believing they provide a low-risk method to match market performance and balance other assets like bonds and international stocks. However, the S&P 500 has changed significantly in composition and risk profile over the years.

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My research assistants, Reema Hammad and Raheeg Joari, and I analyzed data on the S&P 500 over the past 50 years to understand these changes. We looked at how its components have evolved, affecting its sensitivity to interest rates, dividend yield, and volatility.

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Key Finding: Increased Concentration in Tech and Financial Stocks

The S&P 500 has become more concentrated in technology and financial sectors, making it more sensitive to interest rates and more correlated with global indexes. This has important implications for diversifying stock portfolios.

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Shift in Composition

In the 1970s, industrials and materials made up 26% of the S&P 500. Today, they account for only 10.6%. Meanwhile, the information technology and financial sectors have grown from 13% of the index in the 1970s to 42% today, with tech alone representing 29 percentage points. Currently, six of the top seven positions in the S&P 500 by weight are in the tech sector, meaning investors in the S&P 500 face risks similar to directly holding tech firms—interest-rate risk, high valuations, and lofty growth expectations.

Valuation Changes

Valuation levels have risen since the 1970s. The average Shiller CAPE (cyclically adjusted price-to-earnings) ratio, which adjusts for inflation and averages earnings over ten years, was 13.5 in the 1970s and climbed to over 30 by the early 2020s. This indicates the U.S. stock market's increased sensitivity to interest rates. With high expectations for earnings growth, even minor interest rate changes can significantly impact valuations. For example, when the Federal Reserve raised rates by 5 percentage points in 2022, the S&P 500 dropped by 20%.

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Dividend Yield Decline

The S&P 500’s dividend yield has fallen from 4.11% in the 1970s to 1.45% in the 2020s. Dividends help reduce stock volatility by cushioning losses, so the significant decrease in dividend yield means the S&P 500 has lost a crucial stability factor over the decades.

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Increased Correlation with Global Indexes

The correlation between the S&P 500 and top global stock-market indexes (from countries like Germany, the U.K., France, South Korea, Hong Kong, Japan, Canada, China, Mexico, and Brazil) has increased steadily. In the 1970s, the average correlation was just 0.24, meaning returns in different parts of the world often varied independently. By the early 2020s, this correlation had jumped to 0.70, indicating that global markets now move more in sync with each other.

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This higher correlation impacts diversification strategies. In the 1970s, adding a few international indexes to U.S. holdings significantly reduced risk. Today, adding indexes like Germany’s DAX or the U.K.’s FTSE does not reduce portfolio volatility much because they are too highly correlated with the S&P 500.

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Implications for Diversification

The modern S&P 500 is heavily weighted towards tech, highly correlated with other global indexes, sensitive to interest rates, and lacks the strong dividend yield it once had. Therefore, the traditional 60-40 portfolio mix (60% stocks, 40% bonds) that effectively addressed diversification in the 1970s is less effective now. Simply adding international stocks for diversification no longer works as well.

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To achieve the same diversification benefits as in the past, investors need to adopt more creative strategies. This includes incorporating not just stocks and bonds, but also commodities, alternative assets, and other asset classes that are uncorrelated or weakly correlated with the S&P 500.

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In summary, the S&P 500 has evolved dramatically over the past 50 years, becoming more concentrated in tech and financials, more sensitive to interest rates, and more correlated with global markets. These changes necessitate a reevaluation of traditional diversification strategies to ensure robust portfolio performance.

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