Are there more risks with indices?
- Thread starter MarkDawn
- Start date
Less risk with indices because they are diversified.
Less profit potential with indices because they are diversified.
Less profit potential with indices because they are diversified.
Well, by definition indices should be less risky than individual stocks because they are diversified (i.e. holding a basket of stocks), however, dig deeper in the index you are looking at and you will find wonders.
For example, the S&P500 top 5 holdings are Apple, Microsoft, Amazon, Facebook & Tesla. I don't have the weights of the those top 5 (It's not published and it's a pain to manually calculate).
However, the point is that, those top 5 constituents weights combined will be around 20% (Ballpark).
It's clearly a skew, since what happens with those 5 companies greatly affect the index, hence, it's not as diversified as it should be.
Another point, the Technology sector weight in the S&P500 is around 27% and Healthcare is around 13.5%. So 2 sectors only are 40% of the index, it's again a skewed exposure (At this point in time because the weights do change).
For example, the S&P500 top 5 holdings are Apple, Microsoft, Amazon, Facebook & Tesla. I don't have the weights of the those top 5 (It's not published and it's a pain to manually calculate).
However, the point is that, those top 5 constituents weights combined will be around 20% (Ballpark).
It's clearly a skew, since what happens with those 5 companies greatly affect the index, hence, it's not as diversified as it should be.
Another point, the Technology sector weight in the S&P500 is around 27% and Healthcare is around 13.5%. So 2 sectors only are 40% of the index, it's again a skewed exposure (At this point in time because the weights do change).
Any diversification is less risky than individual stock.
Who's to say "how much diversification is the correct amount"?
Even in a "sector fund/ETF," where assets are concentrated... they are still "diversified vs individual stocks".
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With indexes they are regularly rebalancing the component stocks so you are very unlikely to have a stock in an index go bankrupt. If you look at the stocks in the DOW in 1929 and then compare that with todays DOW, I think the only stock in both is GE. The indexes are always adding the new winners, TSLA being a recent example in the S&P 500, and winnowing the losers. Pfizer, Raytheon and Exxon recent examples in the DOW.
I assume you are young. If so, you have an edge I will never have again and I would urge you to get in the habit of dollar cost averaging into a blue chip index...SPY, DOW, IWM, IJR. Those last two are small caps which will see the strongest growth, and will probably be the most volatile.
If you look at the normal returns over a long period of time, the chart will start out just slightly rising at first and then it will go parabolic. Your returns much later in your life will be exponentially higher than the first few years. That's why it is so important to start young so you give it time.
I assume you are young. If so, you have an edge I will never have again and I would urge you to get in the habit of dollar cost averaging into a blue chip index...SPY, DOW, IWM, IJR. Those last two are small caps which will see the strongest growth, and will probably be the most volatile.
If you look at the normal returns over a long period of time, the chart will start out just slightly rising at first and then it will go parabolic. Your returns much later in your life will be exponentially higher than the first few years. That's why it is so important to start young so you give it time.
No doubt about that, true.
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They weight those tech companies like that for good reasons /QQQ has a much greater tech % + almost always outperforms SPY.
IN the long run, not much risk if one dollar cost averages. Start early,but almost no ones puts a years worth of money in, in JAN.
MAR maybe a bigger risk than NOV/but thats short term.
While those companies do represent a larger portion of the index, it is the correct weighting. S&P500 is an approximation of the Tangency Portfolio. This portfolio reduces all idiosyncratic risk to as low as possible, leaving only systemic risk. Phrased differently, there is no additional safety you can get by diversifying more. See https://en.wikipedia.org/wiki/Modern_portfolio_theory
The academic understanding of risk is variation in the returns of assets. Having a well defined risk metric will help you answer how much risk there is in indexes. For example, if the S&P500 shot up in value, is that a risk? Most people would say no, but if you were short the index (or, you cashed out just before), you would lose a lot of money. Risk is how far away, down or up, the return is from the expectation.
Indices reduce risk because assets in the index have co variances. By combining the assets together in an index portfolio, the covariances cancel out. This in turn lowers the overall variance of the index, and thus is "lower risk". As others have mentioned, the return is also lower. But, this is actually a great deal, because the return is linearly lowered. You get a weighted sum of the returns of the assets. The risk is reduced quadratically, which is significantly more than the loss in return. You lower your return a little bit, but reduce the variance a lot. If you want to ratchet the return back up, you can leverage this index portfolio up the the desired level of risk/return. The key in this is that the variance needs to be low in order to safely leverage.
Tl;Dr: Indexes are safer than individual stocks. More clarity about that indexes you are interested will get a more precise answer.