The Stock Market's Biggest Winners Are Hiding a Problem. This Is How I'd Protect My Portfolio.

Many investors think that owning more stocks or exchange-traded funds (ETFs) automatically means portfolio diversification.

It may. But it depends entirely on what you’re buying. Unfortunately, today’s U.S. stock market is as top-heavy and concentrated as it’s ever been. Because of that, a lot of portfolios own multiple funds that essentially look the same.

The Vanguard S&P 500 ETF (VOO +0.61%), for example, is a perfectly acceptable choice for the core of your portfolio. But it’s not perfect. It’s currently got 38% of its assets invested in tech stocks and 37% of its assets invested in the index’s top 10 holdings. Even in a fund that owns hundreds of stocks, its performance depends heavily on fewer than 10 companies.

How you choose to build around that core determines whether you’re actually diversifying or just complicating the problem.

Additional ETFs might not add much diversification at all

Investors are usually inclined to invest in whatever is performing well at the time. Over the past few years, that means they’ve probably loaded up on funds such as the Vanguard Growth ETF (VUG +0.72%) and the Vanguard Information Technology ETF (VGT +0.57%). But look under the hood of those funds, and you’ll immediately see the problem.

The Vanguard Growth ETF has 80% of its assets invested in tech. Nine of its top 10 holdings are identical to those of the S&P 500 (^GSPC +0.59%). It’s got 63% of its assets in the top 10 holdings.

The Vanguard Information Technology ETF tells a similar story. Its top three holdings — Nvidia (NVDA -0.52%), Apple (AAPL -1.11%), and Microsoft (MSFT +2.38%) — are the same as the S&P 500, but alone account for nearly half of the portfolio.

The commonality among all three ETFs is that they’re incredibly concentrated in just a handful of the same megacap tech stocks. If you buy the Vanguard Growth ETF or the Vanguard Information Technology ETF thinking that you’re diversifying your core S&P 500 position, you’d actually be making your portfolio even more concentrated.

Here’s what I’d pair with the S&P 500 instead

If you want true diversification with U.S. stocks, I’d choose bonds, gold, or maybe international equities.

But if you don’t want to drift too far from what’s currently working with U.S. large caps, take a look at the Invesco S&P 500 Equal Weight ETF (RSP +0.55%). You get the same 500 stocks as the big index, but reallocated in a way that gives you true diversification within this category.

It’s got 9%-plus allocations in five different sectors, including tech, giving it much more balanced exposure to U.S. equities.

None of this is to suggest that you should sell your growth or tech ETFs today. But it’s a good reminder to always look under the hood and understand what you own. Then you can truly protect your portfolio from unusual risks.