The Biggest U.S. Stocks: Expert Advice on Avoiding Greed

Low-cost S&P 500 funds have traditionally been a cornerstone of many investment portfolios, with a 90/10 split between the index and short-term treasuries famously advocated by Warren Buffett as sufficient for long-term investors.

Indeed, the S&P 500, representing 80% of total U.S. market capitalization, has historically been a strong performer, more than quadrupling in value over the past decade. However, an overreliance on the largest U.S. public companies, as reflected in market-weighted S&P 500 ETFs, presents concentration risks. This is largely due to the outperformance of the information technology sector, leading some investors to draw parallels with the dot-com bubble of 2000-2002. This strategy is particularly perilous for individuals nearing retirement who may need to access their portfolios for income.

"This S&P 500 isn't your father's index," notes 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 mitigate volatility by incorporating exposure to other equity markets and uncorrelated assets.

What S&P 500-Focused Investors Miss Out On

Goldberg points out that the five smallest sectors in the overall stock market – consumer staples, energy, utilities, real estate, and materials – constitute only 14% of the S&P 500, impacting the index's overall diversification and risk profile. He suggests that investors consider an equal-weighted S&P 500 index to gain exposure to these 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 explains. "Adding non-correlated investments can improve your overall portfolio and is crucial in a bear market, when you don't want all your investments to move in tandem."

Excessive exposure to the S&P 500 also creates opportunity risk, as other investment types may offer higher potential gains.

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

Investments beyond the S&P 500 can also offer better valuations. "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," says Ankur Patel, chief investment officer of Ellevest.

Neena Mishra, director of ETF research at Zacks Investment Research, notes that investors can reduce volatility by turning to other value investments. She recommends dividend-growth ETFs, such as the Schwab U.S. Dividend Equity ETF (SCHD), which prioritizes 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 observes.

Within fixed income, she prefers 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." Furthermore, in the current environment of persistently elevated inflation and continued interest rate volatility, longer-duration fixed-income ETFs are inherently riskier. Consequently, 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. "These cash-like instruments offer low risk along with a decent level of income," she adds.

Mishra also suggests considering gold, a commodity valued since antiquity. "I believe gold deserves a place in any diversified portfolio because of its low correlation with traditional asset classes," she states, noting that State Street's SPDR Gold MiniShares Trust (GLDM) and BlackRock's iShares Gold Trust Micro (IAUM) are cost-effective options for long-term investors.

Can You Handle a 20% Market Decline?

Patel advises investors to consider their time horizon when assessing their S&P 500 exposure. "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 explains that determining exposure depends on 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."

The specific impact of artificial intelligence holdings on S&P 500-heavy portfolios should also be considered when investors seek diversification. The volatility risks associated with AI stem not only from market concentration but also from shifting public sentiment and the potential for 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 notes. "Portfolio diversification is often called the only 'free lunch' in investing because combining uncorrelated assets can reduce portfolio volatility without necessarily sacrificing expected returns."

There's no doubt that funds tracking the S&P 500 have been an effective tool for wealth building, especially since the advent of the 401(k), which facilitated a long-term, straightforward 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," Goldberg concludes.

A low-cost S&P 500 index ETF is an excellent vehicle for long-term wealth growth, but investors should also consider adding uncorrelated assets to diversify their portfolios and reduce volatility.