Your S&P 500 Index Fund is REALLY NOT Diversified Now

Your S&P 500 Index Fund is REALLY NOT Diversified Now

Today, I want to revisit a topic that’s close to my heart and central to my investment philosophy: the ongoing debate between indexing and active management.  Two years ago almost to the date, I discussed in a podcast episode how a few large stocks were dominating the S&P 500 index, contributing to significant concentration risk.  This is because of how the index is actually calculated when it comes down to it.  It is what they call a market-capitalization-weighted index.  Or in English, it means that bigger companies have a bigger impact on the return of the SP 500.  If you thought that concentration was concerning then, buckle up—because the rise of artificial intelligence (AI) has only amplified this trend.

The Growing Weight of the Largest 7 Companies

Back in 2021, I looked at the top five companies—Apple, Microsoft, Amazon, Facebook, and Alphabet—and they accounted for over 20% of the S&P 500’s weight.  Fast forward to today, and the top seven companies (seven b/c everyone has been talking about the “Magnificent 7”)—Apple, Nvidia, Microsoft, Amazon, Meta, Google, and Berkshire Hathaway—now control nearly 30% of the index’s weight.  This increase in concentration is largely driven by the explosive growth of AI technology and the inclusion of Nvidia, which has become the world’s largest company at times.  It should also be noted that when the “Mag 7” is referenced, that reference usually had Tesla in it but at the time of me writing this blog, because of Tesla's recent poor market performance Berkshire Hathaway is larger.  

 A 50% Increase in Just Two Years

This 30% concentration, up from 20% two years ago, marks a staggering 50% increase in just two years.  The rise of AI has been nothing short of transformative, and companies leading this revolution have seen their stock prices skyrocket.  Nvidia, in particular, has been at the forefront, with its chips powering the AI algorithms that are becoming increasingly integral to various industries.  This meteoric rise has further concentrated the S&P 500, with the largest seven companies now holding nearly 30% of the index’s weight—a sharp increase from just two years ago.

What Does This Mean for Your Portfolio?

If you’re invested in an S&P 500 index fund, it’s essential to understand what this concentration means for your portfolio.  Yes, these tech giants have driven much of the market’s recent growth, but this also means that your portfolio’s performance is increasingly tied to the fortunes of just a few companies.  This concentration risk can be a double-edged sword—while it’s great when these companies perform well, it also exposes you to significant downside if they stumble.

The Case for Diversification

This growing concentration is why I continue to advocate for a diversified approach to investing. Research consistently shows that diversification is one of the best predictors of long-term success in the market.  A well-diversified portfolio spreads risk across various asset classes, sectors, and geographic regions, reducing the impact of any single investment’s poor performance.  This approach can help smooth out returns over time, providing a more stable foundation for achieving your financial goals.

 A study by Fidelity, for instance, found that a diversified portfolio, even during periods of market stress, tends to recover more quickly and with less volatility than a concentrated portfolio.  This is because diversification mitigates the risk associated with overexposure to any one sector or group of companies.  As the market evolves, maintaining a diversified portfolio remains a tried-and-true strategy for weathering the ups and downs and capturing long-term growth.

 Younger Investors vs. Near-Retirees: Different Strategies for Different Stages

It’s important to recognize that the best investment strategy can differ significantly depending on your stage of life.  For younger investors who are still in the accumulation phase, a pure indexing approach might make more sense.  The reason is simple: time.  Younger investors have the luxury of time on their side, allowing them to weather the ups and downs of the market, including potential large losses.  Over time, the broad market has historically trended upward, and younger investors can afford to ride out periods of volatility, knowing they have decades to recover and benefit from compounding returns.

 However, the situation is markedly different for those nearing retirement.  As you approach the point where you’ll need to start drawing down on your investments, the stakes become higher.  A significant market downturn can have a much more detrimental effect because there’s less time to recover before you need to tap into those funds. And so don’t even get me started on nerding out on Sequence of Returns Risk…but I digress for today.  This is why a more diversified approach, perhaps with active management that includes a mix of asset classes and sectors, becomes increasingly important for near-retirees.  Protecting what you’ve accumulated and managing risk becomes the priority over chasing high returns.

Common Rebuttals from Indexing Advocates—and Why They Fall Short

Proponents of pure indexing often bring up some familiar arguments to support their strategy.  While there’s truth to their points, it’s important to examine these arguments more closely, especially when considering your individual situation.

 "The market always comes back."

Sure, the market has historically recovered from downturns, but the key question is when it will come back.  There’s no guarantee on the timing of a recovery, and prolonged periods of underperformance can significantly impact your financial plan—especially if you’re close to or in retirement.  For example, have you heard about the “Lost Decade”?  Between 2000 and 2010, the S&P 500 essentially delivered zero return.  If you were relying on that market to fund your retirement during that period, you could have faced significant challenges.  It’s a stark reminder that while the market may eventually recover, the journey can be volatile and unpredictable.

 "The S&P 500 averages 10% a year."

Yes, historically, the S&P 500 has averaged around 10% per year, but that’s an average, not a guarantee.  To reach that average, the market experiences significant volatility, with periods of large gains often offset by periods of substantial losses.  The standard deviation, which measures the amount of variation or dispersion from the average, is around 15% annually for the S&P 500 going back 10 years.  Over the last 5 years that is over 18% (source: yahoo.com).  This means that in any given year, returns can be significantly higher or lower than that 10% average.  Understanding this volatility is crucial, especially for investors nearing retirement who may not have the time to recover from large downturns.

 "Indexing is low-cost and simple."

It’s true that index funds often come with lower fees and are easier to manage compared to actively managed investing.  However, simplicity and low cost don’t always equate to the best outcomes.  If you’re overly concentrated in a handful of companies, as we’ve seen with the current state of the S&P 500, your portfolio might be exposed to more risk than you realize.  Diversification might come at a slightly higher cost, but it can provide valuable risk management benefits, especially in uncertain market environments.

Closing Thoughts

As I’ve always said, it’s important to know what you’re invested in.  The rise of AI and the resulting concentration in the S&P 500 highlight the need for careful portfolio construction and a deep understanding of the risks involved.  If you’re unsure about how concentrated your portfolio is, it might be time for a portfolio review.

I hope I’ve given you some valuable insights to consider as you continue on your financial journey.  Remember, I’m here to help you navigate these complexities, so don’t hesitate to reach out if you have any questions or concerns.  Until next time, stay informed, stay diversified, and be well.

-written by Ryan Hitchcock, CPWA®, High Point Capital Group, Milwaukee, WI 53226