U.S. stocks have done great for you. Don’t be greedy in this market

Low-cost S&P 500 funds are the foundation of many portfolios, and holding a portfolio with a 90/10 split between the index and short-term treasuries has been famously championed by Warren Buffet as all that long-term investors need.

Indeed, the S&P 500, which represents 80% of total U.S. market capitalization, has been a long-term winner – more than quadrupling in value over the last decade. But by focusing only on the biggest public companies based in the U.S., popular market-weighted S&P 500 ETFs – including Vanguard’s VOO, BlackRock’s IVV and State Street’s SPY – pose concentration risks to investors because of outperformance in the information technology sector. This has driven some agitated investors to see parallels between the current market and the conditions leading up to the dot-com crash of 2000-2002, when the overall S&P 500 lost nearly half its value. It’s a particularly risky way to invest for those nearing retirement who may need to draw on market portfolios for income in the years ahead.

“This S&P 500 isn’t your father’s index,” said Mitch Goldberg, president of ClientFirst Strategy. “It’s super-powered by the information technology sector, which makes up about 37% of total value. Adding in the communications sector, which includes companies like Meta and Netflix, brings it to almost 50%.”

Investors can seek to limit volatility by adding exposure to other equity markets and uncorrelated assets.

What S&P 500-focused investors ‘miss out’ on

Goldberg noted that the five smallest sectors of the overall stock market – consumer staples, energy, utilities, real estate and materials – make up only 14% of the S&P 500, which impacts the overall diversification and risk profile of the index. He said investors should consider an equal-weighted S&P 500 index to add exposure to those sectors, as well as adding fixed income, international equity and small-cap domestic equity to their portfolios.

“Diversification helps you avoid becoming dependent on yesterday’s winners, which is a form of recency bias,” Goldberg said. “Adding non-correlated investments can improve your overall portfolio, and is important in a bear market, when you don’t want all your investments to move in tandem,” he said.

Overexposure to the S&P 500 also creates opportunity risk, as other types of investments have the potential for higher gains.

“If your exposure in the S&P 500 is too high, you’re missing out,” said Todd Rosenbluth head of research & editorial at TMX VettaFi. He pointed out that investments such as small-cap and international equity have been beating the S&P 500 this year, with prominent examples including the iShares Core S&P Small-Cap ETF (IJR) and the iShares Core MSCI Emerging Markets ETF (IEMG).

Investments outside the S&P 500 can also be better valued, said Ankur Patel, chief investment officer of Ellevest. “The S&P trades around 20 times forward earnings while developed international and emerging markets sit closer to 10-15x. You’re paying a lot less for each dollar of earnings overseas.”

Neena Mishra, director of ETF research at Zacks Investment Research, noted that investors can lower their volatility by turning to other types of value investments. For instance, she recommends investors hold some of their portfolios in dividend-growth ETFs, such as the Schwab U.S. Dividend Equity ETF (SCHD), which focuses on the quality and sustainability of dividends. “Health care, consumer staples, and energy receive the largest allocations in the portfolio, helping investors diversify away from the mega-cap tech giants. It has also significantly outperformed the S&P 500 Index this year,” she said.

Within the fixed income space, she favors shorter-term government bonds over corporate, high-yield, and long-term government options. “Many investors are still scarred by 2022, when both stocks and bonds nosedived as inflation surged,” she said. Further, in the current environment of persistently elevated inflation and continued interest rate volatility, longer-duration fixed-income ETFs are inherently riskier, according to Mishra. That is why ultra-short treasury bill ETFs like the iShares 0-3 Month Treasury Bond ETF (SGOV) and the Vanguard 0-3 Month Treasury Bill ETF (VBIL) have become very popular with investors. “These cash-like instruments offer low risk along with a decent level of income,” she said.

Mishra also suggested investors consider a commodity popular since antiquity: gold. “I believe gold deserves a place in any diversified portfolio because of its low correlation with traditional asset classes,” she said, noting that State Street’s SPDR Gold MiniShares Trust (GLDM) and BlackRock’s iShares Gold Trust Micro (IAUM) are low-cost options for long-term investors.

Can you handle a 20% market decline?

Patel advises investors to look at their time horizon when determining if they might have too much exposure to the S&P 500. “Here’s one way to think about it: if the S&P 500 fell 20% tomorrow, would it change your plans? If the answer is yes, you’re overexposed.”

He explained that determining exposure comes down to an investor’s goals. “Think about it less in terms of age and more in terms of when you actually need the money. Money you won’t touch for 10-plus years can be more aggressively allocated. Money you need in the next few years shouldn’t depend on what Nvidia reports next quarter. Buffett’s 90/10 rule is fine if you have a few decades and the tolerance for it, but not if you need a down payment on a house in, say, a few years,” he said.

The specific impact of artificial intelligence holdings on S&P 500-heavy portfolios should also be considered when investors are looking to diversify. The volatility risks of AI can come not just from market concentration, but also changing public sentiment and the risk of regulatory changes. “The information technology and communication services sectors together make up almost half of the portfolio and are dominated by AI-related names,” Mishra said. “Portfolio diversification is often called the only ‘free lunch’ in investing because combining uncorrelated assets can reduce portfolio volatility without necessarily sacrificing expected returns,” she added.

There is no denying that funds that track the performance of the S&P 500 have been a great tool to build wealth in a diversified product, according to Goldberg, especially since the invention of the 401(k), which sparked a decades-long, one-way investment decision for retirement savers. “But now I can’t help but feel that people have heard that story for so long that they think it’s a risk-less investment,” he said.

A low-cost S&P 500 index ETF is a great way to grow wealth in the long-term, but investors should also consider adding uncorrelated assets to diversify their portfolio and lower volatility.