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SUPPOSE YOU WANTED to construct as simple an investment portfolio as possible. What would it look like?
Many argue that, for stock market exposure, you could go with a single fund, one that tracks the S&P 500 index. The S&P index offers broad diversification and tax efficiency, plus it includes the largest and most successful companies, making it 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.
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 also it’s 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.
A third 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 easy ways to address these concerns. You could hold the S&P 500, but then add to it to build a more balanced portfolio. You could include 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. While these 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 (symbol: RSP), Microsoft carries a weighting of just 0.19%. That’s in contrast to the standard S&P 500, where 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, up 394%, small- and mid-cap stocks with their 370% gain, 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 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’ll perform differently. That can provide flexibility when it comes time to rebalance a portfolio or to take withdrawals. Suppose a retiree held two funds in his portfolio, one of which had a gain and one was at a loss. To take a withdrawal, this retiree could sell a bit from each fund, thus moderating the 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 at all-time highs. That’s an understandable concern. The reality, though, is that the market is often at all-time highs. Since historically the market has risen in about three-quarters of annual periods, it makes sense that it would frequently be at new highs. In fact, the data show, 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—are 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 increase our wealth while also sleeping at night.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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Nice piece. Quick question if you don’t mind. In your article you said the following (which I agree with completely)...”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.” Could you elaborate on how that split should be determined in your mind? Certainly a number of factors come into play…nest egg, age, life expectancy, income needs, withdrawal % needed to meet living expenses, risk tolerance, and on and on. Tough question, but any thoughts would be appreciated.
You might start by leafing through this chapter of HumbleDollar’s money guide:
https://humbledollar.com/money-guide/investing/
Diversifying into foreign stocks hasn’t worked too well in n years, when markets crashed in the US, so did foreign markets.
I read recently that a handful of stocks have always been the driving force behind market gains, all the way back to the great depression.
Thanks Adam for a great article.
The flip side of this is if we try to make our portfolio more conservative, we miss the upside of the magnificent 7. I have reaped a lot of gains in S&P500 and VTI from these 7 companies. I am ok giving up a little of that temporarily. Long term, these companies still have lots of upside.
My concern is the same concentration in the Vanguard Total Market Fund. The same applies to the comparable funds at the other big mutual fund companies. The Vanguard version has around 3,000 holdings (I think), not 500, but I’m sure the “Mag Seven” are causing close to the same level of overweighting there as in the S&P.
Wouĺd you consider VYM and SCHD another strategy to look for diversification of stock holdings? Another justification being that in a down market, divdends would continue to be reinvested leading to more gains when the market rises again.
A few days ago I received an email from Vanguard with a link discussing their S&P500 fund (eg, VFIAX). The fund’s designation has been changed from “diversified” to “undiversified” for the very reasons discussed by Mr Grossman.
It sounds like some index funds may need to be reclassified too!
That’s fascinating — and entirely justified. I’m not sure many other fund companies are so pro-active in warning investors.
The top 5 account for around 30% of the overall index, but this isn’t as unusual as we’ve been told. If you look beyond the 30 year time horizon of those trying to scare us, you’ll find the market was even more concentrated in the past. At one time AT&T alone was 13% of the market.
See “200 years of market concentration” by Bryan Taylor.
https://globalfinancialdata.com/200-years-of-market-concentration
If I was limited to only one fund, my choice would be a balanced fund like VWELX (60-40)or VWINX(30-70) . Do your research.
Nobody has provided me with a compelling argument in favor of bond funds. I understand (and own) fixed income securities, but don’t see why I’d pay a fee for this and also have to incur the risks and expenses of trading changing the underlying value. Maybe this is an invitation for an article by someone?
You might check this out:
https://humbledollar.com/money-guide/great-debates-bonds-or-bond-funds/
If you like relatively high expense ratios.
I’m a little surprised that the example you use is the S&P 500. I don’t consider that diversified. If I want simple and diversified I think a similar article needs to be written using VTI or VT as examples of diversification. As always I appreciate and look forward to your weekly articles
Using Vanguard or Schwab’s total market funds as the index investment, not S&P500, doesn’t change the point of the story. The stocks at the top may have slightly lower weightings, but they still dominate. It’s a power distribution. Like the distribution of indivual wealth.
“This leads 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.”
I think keeping this in mind will save us all a lot of time and sanity. It’s easy to agonize over the types of stock investments – world vs total stock/international, total stock vs sp500/value/mid/small, international vs developed/emerging, etc. – and bond investments – total bond vs short/intermediate/long, international bond, etc.
The choices are endless. But in the end, these choices are far less impactful to your total return than the overall stock/bond allocation of the portfolio. Pick your core investments, forget about the other choices, and spend your analysis on whether your stock/bond allocation is appropriate.
Us retirees have too much time to think about these things
Adam, thank you for a reminder that a healthy dose of humility is the best approach to building a portfolio. Over-confidence. or just a willful ignorance of risk, is dangerous to our wealth.