Sector Weightings Skew Individual Investors' Results

Article excerpt

Despite the credit market's trials and tribulations -- and $95 crude oil -- the stock market had a relatively productive October.

The S&P 500 index rose 1.48 percent to bring its year-to-date total to a 9.24 percent gain. October's results were nearly half of a percent higher than the 58-year average for the month.

Results for the S&P 500 or any other market index, however, can be misleading.

The S&P 500 consists of 10 weighted industry sectors. For most of its history, the index was market-value weighted by considering all outstanding shares in all the companies. Recently, the index was "float" weighted. Only shares that Standard & Poor's determines are available for public trading are considered now. Shares not in public hands are excluded from the calculation. Not only are the stocks weighted, but so are the sectors. The financial sector's 19.25 percent weighting by far is the largest. The materials sector on the other end of the spectrum represents only 3.33 percent.

The differences in sector weightings can have a significant effect on individual investors' results.

After the major market drop in 2000, diversification was widely touted as being the magic elixir for reducing risk and improving portfolio results. This led many investors to structure portfolios to match sector weightings of the S&P 500.

The S&P 500's 9.24 percent gain by the end of October certainly was not bad, but had an investor merely given all 10 sectors equal emphasis, their return would have been 12.67 percent by the end of October.

The difference between the weighted S&P results and an unweighted portfolio largely stemmed from an 8.68 percent drubbing in the financial sector.

There are three major considerations in making an equity investment: what the market will do, which sectors will do the best and what stocks are best. Although most security analysts do not want to accept it, stock selection is dramatically less important than making good sector selection and gauging the market's direction correctly. …