Suppose you wanted to construct an investment portfolio as simply as possible. What would it look like?
Many argue that for stock market exposure you could go with just a single fund: one tracking the S&P 500 Index. Among the benefits, the S&P index offers broad diversification and tax efficiency. And it includes the largest and most successful companies. For all these reasons, the S&P 500 is a popular choice. But it’s not perfect.
The S&P 500, like many market indexes, holds stocks in proportion to their size, meaning that the most valuable companies carry the largest weightings. There’s a logic to this, because it mirrors the overall market, but sometimes it can lead to distortions. That’s the case today. A handful of the largest companies—mostly in technology—are orders of magnitude larger than nearly every other company in the index. The top five—Microsoft, Nvidia, Apple, Amazon and Google parent Alphabet—each carry valuations north of $2 trillion. By contrast, the average market value of the other 495 stocks is just $71 billion. As a result, because they’re weighted by value, those top five companies account for almost 29% of the overall index—an enormously disproportionate share.
Why is this a problem? In recent years, it hasn’t been. In fact, it’s been a great benefit. These stocks have vastly outperformed their peers, and because of their disproportionate weighting, they’ve helped drive the overall index up. But at the same time, it also means that the S&P now carries more risk. If any one of those top five ran into a problem, it could materially affect the overall index. Just as their sizable weightings helped to drive the market up, the reverse could be true.
Some, in fact, think the effect could be magnified if one or more of the largest companies in the index were to run into trouble. One well known market observer is Michael Burry. Because he was the central character in Michael Lewis’s The Big Short, he’s seen as a reliable voice in the industry. So it rattled some investors when he painted this picture of index funds: “The theater keeps getting more crowded,” he said, “but the exit door is the same as it always was.” That was in 2019, and the market has only become more top-heavy since then. Back then, the top 10 stocks accounted for just 19% of the total. Now the top five are 29%.
A second concern: Not only has the index become more top-heavy, but it’s also become less diversified. According to recent research by Derek Horstmeyer, a professor at George Mason University, today just two industries—technology and financial services—account for 42% of the overall index. This represents a risk because stocks in the same industry tend to be more highly correlated with each other than with stocks in other industries. Among the top 10 stocks in the S&P today, eight are in technology.
Another concern is valuation. Since 1985, the price-to-earnings (P/E) ratio of the S&P 500 has averaged 15.7. But today, it stands considerably higher, at 21.6. By contrast, the S&P 500’s closest international peer, the EAFE index of developed markets, is no more expensive today than it was 20 years ago. And while P/E ratios aren’t guaranteed predictors of future performance, they are indicative of risk.
Fortunately, there are readily available solutions to these concerns. In building a portfolio, you could hold the S&P 500, but as just one holding, then add to it in ways that produce a more balanced result. You could add funds with exposure to international stocks, to mid- and small-cap stocks and to value stocks, all of which are trading at more reasonable valuations than the S&P 500. While those other stocks are all included in total-stock market and total-world stock market indexes, the benefit of owning them separately is that it would allow you to control the weightings so they wouldn’t be overshadowed by the top-five behemoths.
Another way to achieve more balance would be to opt for a version of the S&P 500 that weights each component equally, rather than weighting them by size. In the Invesco S&P 500 Equal Weight ETF (ticker: RSP), Microsoft carries a weighting of just 0.19%. That’s in contrast to the standard S&P 500, in which Microsoft’s weighting is 7.2%.
Those are the mathematical answers, but in thinking about this decision, it’s worth taking a step back. There are bigger-picture ideas to consider. For starters, it’s important to view these performance differences in perspective. Over the past 20 years, the S&P 500 has returned a cumulative 550%. That has far outpaced value stocks, which have gained 394%, small- and mid-cap stocks, which have gained 370%, and developed international markets, which have returned just 130%. Those are significant differences—but the returns of bonds pale in comparison to the returns of all stock markets. Over the past 20 years, total-bond market funds have returned just 30%. This leads us to an important conclusion: When constructing a portfolio, the most important decision hinges on the split between stocks and bonds. That decision is far more consequential than the choices we make among different stocks.
It’s important also to recognize another reality about investments: We only know what the past has looked like. And while that might serve as a guide, ultimately, there are no guarantees. The future may—and probably will—develop in ways that are hard to foresee. That’s why I’m an advocate of what I call a “center lane” approach: In constructing a portfolio, try to build in enough diversification that you’ll benefit no matter which corners of the market end up leading the way.
In diversifying beyond just one fund, there are other benefits too. While we can’t know in advance how each segment of the market will perform, we can be sure that they will perform differently. That can provide flexibility when it comes time to rebalance a portfolio or to take withdrawals. Suppose for example, a retiree held two funds in his portfolio, one of which was at a gain and one at a loss. To take a withdrawal, this retiree could sell a bit from each fund, thus moderating his tax impact.
A final point: With the S&P 500 having delivered such impressive gains over the past 15 years, you might worry about buying in at all-time highs. That’s an understandable concern. The reality, though, is that the market is often at all-time highs. Since the market has risen in about three-quarters of annual periods historically, it makes sense that it would frequently be at new highs. In fact, the data shows, counterintuitively, that market returns are higher for purchases made on days when the market is at all-time highs.
Of course, this data—like all data—is backward-looking, and that brings us back to the first point above. Since we can’t know which way the market will go in any given year, the most important thing is to have an adequately conservative split between stocks and bonds. While there are no guarantees in personal finance, this simple formula is, I believe, the best way to grow wealth while also sleeping at night.
