Often you will hear investment advisors stressing the importance of a well-diversified portfolio. While the phrase can sound quite complicated, all it really means is that within your investment accounts it is usually wise to be invested in lots of different things so that if one company or industry falters you don’t lose too much. In other words, the advisor is simply warning against having all your eggs in one basket.
Index funds are a great way to invest in lots of different companies with very little money or effort. The most popular index is probably the Standard & Poor’s 500 Index. The S&P as it is commonly known, tracks the performance of the 500 largest companies based in the US. By investing in an S&P index fund you purchase fractional shares of all 500 of these companies.
The popularity of the index comes in part, to both its generally accurate representation of the entire US economy, and its excellent performance history, having averaged over a 10% annual return over the past 75 years. With these things in mind, it’s understandable why many investors have much of their retirement savings in an S&P fund.
After all, isn’t having your investments spread out amongst 500 different large US companies the diversification what we are told we need? In a lot of ways, the answer is no. Although it is true with an S&P fund you are invested in 500 US companies, you are usually not invested in them equally. Because the largest 25 companies in America are as large as the other 475 combined, when you invest in the S&P half of your investments are in only 25 companies. If you break it down even further and look at only the top seven companies in the S&P, these companies, often referred to as the Magnificent Seven, represent approximately 33% of the total value in the S&P 500. So much for a well-diversified portfolio.
That’s not to say those who have invested heavily in an S&P fund have not received excellent performance in recent years. They certainly have. However, as hopefully we all know, the greater the potential reward the greater the potential risk. Too many investors enamored by the S&P’s performance have convinced themselves they are taking on less risk than they are.
Case in point. A little over two weeks ago, China rocked the tech world with the release of a ChatGPT competitor of DeepSeek, which reportedly was developed for $5.6 million dollars. A far cry from the hundreds of millions, if not billions, it costs to develop and maintain its competitors.
For good reason this sent the prices of many US technology companies stocks plummeting, including several within the magnificent seven. On January 27th alone Nvidia fell by 17%, Google was down 4.2% and Microsoft stock value dropped 2.1%. Overall, this led to the S&P falling by roughly 89 points or 1.5% for the day.
Interestingly, despite these investor fears, if you look at the totality of the companies within the S&P 500 the majority of them actually closed positive. That’s why if you were invested in an equally weighted S&P index, which allocates equal investments in all 500 S&P companies, you actually made money despite heavy losses from the technology sector.
My point in this example is not to say you should invest in an S&P equal weight over a traditional S&P fund. I simply am using this example to show that often what you think you may be invested in may be a far cry from your actual holdings. It’s important that you understand the mechanisms used by these funds, particularly if you are going to be a DIY investor. Or better yet work with a professional whose job it is to understand these things and help you make the investment decisions best for you.
(Past performance is no guarantee of future results. The advice is general in nature and not intended for specific situations)