Brett Arends’s ROI: What Tesla now means for your 401(k)

Crazy? Maybe. But that’s how index funds roll.

Elon Musk’s high-risk, futuristic empire has at last joined the S&P 500 stock index SPX, +0.35%, and that means every fund that tracks the index just had to go out and buy the stock regardless of price, valuation or risk.

We’re not talking petty cash, either. Tesla accounts for about 1.7% of the index by value.

Your S&P 500 or “large cap” index fund now has nearly as much of your retirement money invested in Tesla as it does in real estate or energy stocks.

Never mind that the easy money in Tesla has already been made, by people other than you. The stock went public just over 10 years ago, at $3.40 (in today’s money).

The peak price on Monday? Oh, about $700. (It then fell 6%.)

Index funds have a lot to recommend them, which is why they are so popular. Their fees are typically very low, because you don’t have to pay some overpriced MBA to pick the wrong stocks. They also tend to cost you less in taxes, because they don’t do a lot of buying and selling.

The downside is that a fund that tracks an index like the S&P 500 has to own every stock in the index, regardless of valuation.

Furthermore, the standard index funds don’t invest in all 500 stocks equally. They are what is called “capitalization-weighted,” which means that they put more money in the stocks that are already the most expensive, and the least in the stocks that are least expensive.

Your S&P 500 index fund isn’t betting almost 2% of your money on Elon Musk because they respect the man or the company, but because Tesla is now “valued” on the markets at more than $600 billion.

The more a stock price goes up, the bigger the “market value” of the company. And that means it becomes a bigger part of the index, and a bigger part of every index fund.

So index funds bet the most amount of money on the stocks that have already risen a long way. It’s not the “buy low, sell high” philosophy you might normally expect from an investment manager.

Right now 23% of every S&P 500 index fund is invested in just six highflying tech companies: Apple AAPL, +0.77%, Microsoft MSFT, +0.78%, Amazon AMZN, -0.39%, Facebook FB, -0.26%, Tesla TSLA, +2.44% and “Alphabet” (Google) GOOG, +0.37%. No, really. Those companies account for about a quarter of your fund.

That’s more than its entire investment in the energy, real estate, materials, utilities and consumer staples industries…put together.

The poster child for Wall Street’s insanity during the 1999-2000 dot-com bubble was Cisco Systems CSCO, +0.37%, the telecoms equipment manufacturer, which at the peak traded for 130 times the next year’s forecast earnings.

Tesla today? Try 175 times forecast earnings.

The future makes fools of every forecaster, but it’s worth doing some brief numbers on Tesla right now just to give index fundholders an idea of what they just bought.

At $650 a share, down $50, Tesla in total is now “valued” by Wall Street at $616 billion.

That’s slightly more than the entire stock market value placed on Ford F, -1.45%, General Motors GM, -2.05%, Fiat Chrysler FCAU, -0.79%, BMW BMWYY, +0.23%, Ferrari RACE, +0.08%, Honda HMC, -0.45%, Nissan NSANY, +0.35% and Toyota TM, -0.46% …put together.

There’s a simple way of understanding the math behind a “growth” stock like Tesla. Work out what would have to happen to the business over the next 10 years to make it a reasonable investment.

For example, the U.S. stock market on average has generated returns of around 7% a year (if you expect 2% inflation). For high-risk Tesla just to produce similar returns, the stock will have to grow from $650 today to around $1,250 by 2030. That would value the entire company at just over $1.2 trillion.

According to FactSet, the world’s automobile manufacturers in total made $85 billion in net income in 2019. So in that happy future, where Tesla has produced 7% annual returns for the next decade, the company would have to end up valued at 14 times the industry’s total (recent) income.

And that’s only assuming Tesla earns a modest, stock-market-average return of 7% a year. Who would buy this stock at these levels hoping for only such a mediocre return?

Hoping to make 20% a year from Tesla? If so, then you’re betting the stock will grow from $650 today to $4,000 by 2030, and the company’s entire value $3.8 trillion. That would be 45 times the entire global car industry’s 2019 net income. Good luck with that.

Yes, I know, Tesla is more than just cars. It’s batteries and solar power and Elon Musk’s genius. Will it be nearly $4 trillion worth by 2030?

You’d be hard pressed to find many sane people willing to take this bet at these odds. Luckily, though, there are index funds to do it instead.