Here’s Why You Shouldn’t Just Invest in the S&P 500

Here's Why You Shouldn't Just Invest in the S&P 500

One of the simplest investing strategies today is that of investing exclusively in S&P 500 index funds. While its simplicity is appealing, this strategy could have significant hidden risks for investors. Here’s why you shouldn’t just invest in the S&P 500 and what you should do instead to create a more diversified investment plan.

What Is the S&P 500 Index?

The Standard & Poor’s, or S&P 500, is an index of the 500 largest US stocks by market capitalization. The index is widely seen as a benchmark for the performance of the overall US economy. Thanks to its exposure to a list of America’s largest companies, the S&P 500 is also heavily tracked by index funds. As index funds have grown in popularity over the last several years, many investors have flocked to S&P 500 funds for a perceived combination of diversification and growth.

Why S&P 500 Index Investing Isn’t Actually Diversified

The problem with investing in the S&P 500 index is that it actually offers much less diversification than many investors believe. While the index consists of 500 stocks that span sectors and industries, the weighting of the index presents serious problems. The S&P 500 is weighted by market capitalization, meaning that higher-cap companies make up a larger share of an index fund than those with smaller caps. This may seem sensible enough on the surface, but closer examination reveals significant risks associated with this weighting method.

Under this method, a handful of companies with extremely high capitalizations dominate the composition of the index. At the moment, Amazon, Microsoft, Facebook, Apple, and Google are producing the majority of the S&P 500’s growth. Their high capitalizations also mean they make up a disproportionate amount of the holdings in an S&P 500 index fund. As a result, investors holding these funds are reliant on concentrated tech holdings for their gains, while other sectors are represented at much lower levels. A major downturn in tech, therefore, could slow growth and produce losses for investors who believed they were protected by a supposedly diversified index.

How to Create a More Diversified Portfolio

Given the potential problem of risk in the S&P 500 index, investors must look elsewhere to diversify their portfolios. Following are three critical strategies for implementing diversification at multiple levels.

Invest Across Assets

The first step in comprehensive diversification is investing in a wide variety of assets within the same class. Buying multiple funds allows you to broaden your exposure to various stocks, whereas any single fund could concentrate your risks in the same way as an S&P 500 index fund. The trick, though, is to make sure all of your funds invest in different assets. If you hold an S&P 500 index fund, a growth mutual fund, for example, there’s a good chance the assets held by those funds will overlap significantly. If you buy funds that hold mostly different assets, though, you can achieve real diversification.

Invest Across Asset Classes

You can further diversify your holdings by investing in a variety of asset classes. Investing only in the S&P 500 limits your portfolio to stocks, which can be a risky decision during major market crashes. Holding bonds, cash, real estate, and other assets can help to limit your risk during these periods. The more asset classes you invest in, the more resilient your portfolio will be to shifting market conditions.

Invest Across Time

Finally, you can diversify your portfolio by investing gradually over time. Thanks to fluctuating asset prices, consistent buying allows you to take advantage of higher gains when asset prices are depressed. Setting a regular contribution to your investment account and sticking with it through a variety of market conditions can help you take advantage of the market cycle of corrections and rebounds.

What’s the smarter way to invest?

While diversifying at all levels may seem like a great deal of work, modern investment tools make it surprisingly easy. SmartWealth by NBK Capital allows you to build a fully diversified portfolio and minimize your investment risks in a faster, simpler way.

Sign up with SmartWealth for a fully diversified investment plan today to see how easy it can be to protect your portfolio from the unseen risks of investing in a single index fund.

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