Throughout the year stocks are added and removed from the S&P 500 index with little fanfare. Last December was an exception when Tesla (TSLA) was added to the index. There might be more notable additions in 2021 perhaps Zoom Video (ZM​​​​​​​), Airbnb (ABNB), and Uber (UBER). What will that mean for the index?  More volatility.

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When Standard & Poor’s announced Tesla’s inclusion in their index it was the sixth-largest company with a capitalization of $560 billion. Since the S&P 500 is a capitalization-weighted index, many smaller companies were sold (probably $60 billion to $80 billion worth) to make room for Tesla. How volatile is Tesla? It gained 740 percent in 2020. Even a partial retracement would be a far larger drop than you will see in the other stocks. So far, its volatility is to the upside.   

Standard & Poor’s will likely add even more volatility to the index when they add another large company such as Zoom Video, a $111 billion company whose stock rose 350 percent last year. Other possible additions are Airbnb, Uber Technologies, Square Inc. (SQ), Snap Inc. (SNAP), and DoorDash (DASH). Those stocks all have large capitalizations, have been big winners, and are far more volatile than the S&P 500 index. By adding them, the index will be even more top-heavy with stocks that seemingly move five percent or more on any given day. 

While the inclusion of Tesla and maybe some of the other stocks I’ve mentioned will increase volatility, there is also a message to passive S&P 500 index investors: you are buying high. Remember, Tesla was added to the index after it moved 700 percent. If Zoom Video or any of the other stocks are added it is because they have done well. S&P 500 index investors are, in effect, overweighting stocks that were the biggest winners. This ‘buying high’ effect is one reason the S&P 500 did so poorly after the internet bubble burst in March 2000, when it lost 50 percent over the next two years.

Investing in S&P 500 index funds is extremely popular. The largest mutual funds and ETFs are all tied to the S&P 500. It has worked and will continue to do so because the fees are low and over the long run the market goes up.  Nevertheless, I prefer to hold other passive funds like the Vanguard Dividend Appreciation ETF (VIG). It is more stable because it only holds companies with a record of increasing their dividends year over year. I’m happy not to be buying the previous year’s biggest winners.