There are plenty of ways to categorize stocks. Some investors think of growth stocks versus value or dividend stocks. Or megacap, large-cap, mid-cap, and small-cap if you sort by market capitalization. There’s also a more formal organization technique based on stock market sectors.
According to the most commonly used classification system, there are 11 stock market sectors. At the time of this writing, nine of those sectors are beating the S&P 500 (SNPINDEX: ^GSPC) year to date (YTD). You may be wondering how that is possible, given that the S&P 500 is one of the most well-known stock market indexes. The S&P 500 represents the most valuable U.S. companies, but in some ways, it doesn’t represent the broader stock market well.
Here’s why so many sectors are beating the S&P 500 YTD, what it means for your portfolio, and why it’s important to understand the composition of exchange-traded-funds (ETFs) or index funds before you buy them.
Image source: Getty Images.
In recent years, the most valuable U.S. companies have been leading the broader market higher, which has made the S&P 500 more concentrated.
Nvidia (NASDAQ: NVDA), Apple (NASDAQ: AAPL), and Microsoft (NASDAQ: MSFT) alone make up a combined 19.6% of the S&P 500. Throw in Amazon (NASDAQ: AMZN), Alphabet (NASDAQ: GOOG)(NASDAQ: GOOGL), Meta Platforms (NASDAQ: META), Broadcom (NASDAQ: AVGO), Tesla (NASDAQ: TSLA), and Netflix (NASDAQ: NFLX), and that’s 32.6% of the S&P 500.
All of these companies fall into the technology, consumer discretionary, or communications sectors, which comprise 52% of the S&P 500. Tech alone makes up 30.7%.
However, many of these stocks are underperforming the S&P 500 YTD. In fact, Apple, Amazon, Microsoft, Nvidia, and Tesla are negative YTD, which is dragging down the S&P 500.
^SPX data by YCharts
Meanwhile, industry leaders of other sectors are doing well, which is allowing lower-weighted sectors to outperform the S&P 500 so far this year.
^IXV data by YCharts
When prior market leaders begin underperforming a benchmark, it can be a sign that some folks view those stocks as overvalued. So, they may sell out of those names and turn to other pockets of the market for cheaper growth stocks or switch to value and income stocks.
Bouncing in and out of a sector or theme based on whether it is in favor isn’t a great idea for individual investors. Rather, a better approach is to be aware of how a handful of companies can move the S&P 500 and ensure you know what makes up an ETF or index fund before buying it.
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For example, Meta Platforms and Alphabet make up a staggering 48.5% of the Vanguard Communications ETF (NYSEMKT: VOX) — a fund that mirrors the sector’s performance. Similarly, Amazon and Tesla comprise over 40% of the Vanguard Consumer Discretionary ETF (NYSEMKT: VCR). Apple, Nvidia, Microsoft, and Broadcom make up 48.3% of the Vanguard Information Technology ETF (NYSEMKT: VGT). If you buy a sector ETF, it’s worth understanding that just a handful of companies could drive gains or losses.
Many investors may buy an S&P 500 index fund for broad-based exposure to the stock market. But even the S&P 500 isn’t as diversified as it used to be, given how massive big tech stocks are.
The top 10 companies by market cap in the S&P 500 comprise 37.6% of the index. And the top 25 companies make up 50% of the index. That means just 5% of companies are responsible for half of the S&P 500’s movements. So, if lower-weighted companies are doing well, it may be overshadowed by the moves in larger companies.
When buying individual stocks, it’s essential to have a clear investment thesis, which can include factors such as what the company does well, how the market values it, how it stacks up against the competition, where you hope it to be in three to five years (or longer), and why it is a good fit for your portfolio based on risk tolerance and investment objectives.
When buying an index fund or ETF, you certainly don’t have to know the ins and outs of every holding. After all, most investors buy these funds for broad-based exposure to the general market, a sector, or a theme.
However, it is essential to know how that fund will respond based on different market movements and if it diversifies your portfolio or accidentally leads to more concentration.
For example, if you already have 10% of your portfolio invested in semiconductor stocks — and are happy with the size of the position — then buying an S&P 500 index fund doesn’t provide enough diversification since 7.8% of the index is invested in Nvidia and Broadcom.
It’s also worth noting that your portfolio’s performance may vary wildly from the S&P 500 if you don’t own top components in the index. So, comparing how you stack up against the index has little to do with your stock picks and more to do with whether big tech stocks are in or out of favor.
The dominance of a handful of companies adds an element of concentration risk to the S&P 500. If you have a long-term time horizon, investing in the S&P 500 or individual megacap tech stocks can still be a solid idea. However, concentration risk could make the S&P 500 volatile if there’s a major sell-off in some of the leading names, which is something to keep in mind — especially for risk-averse investors who are choosing an S&P 500 index fund under the assumption it won’t be volatile just because it holds hundreds of stocks.
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Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool’s board of directors. John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Netflix, Nvidia, and Tesla. The Motley Fool recommends Broadcom and recommends the following options: long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft. The Motley Fool has a disclosure policy.
How Are 9 Out of the 11 Stock Market Sectors Outperforming the S&P 500 in 2025? was originally published by The Motley Fool
