Why Every Investor Should Consider the S&P 500 for Portfolio Diversification

Diversification is a pillar of sound investing, with portfolios including a range of stocks, bonds, and collections of investments such as exchange-traded funds (ETFs) and index funds. 

One of the most popular types of ETFs and index funds tracks the S&P 500 Index, which focuses on approximately 500 of the largest publicly traded U.S. companies, and covers approximately 80% of available market capitalization, per S&P Global.

For this reason, investing in the S&P 500 can help balance the investment risk in your portfolio. Because the index includes companies from all sectors of the economy, risk is spread across a broad swath of industries, and you’re less vulnerable to the failure of any single stock.

The S&P 500: Broader Market Exposure and Potential Diversification Benefits

The S&P 500 Includes the World’s Biggest Companies

Think of the largest companies in the world at the moment: Alphabet, Amazon, Apple, Meta, Microsoft, and Nvidia. The stocks of all these companies are included in the S&P 500 Index, along with hundreds of the world’s other most valued companies, and hold significant weight in its value. (Microsoft, Nvidia, and Apple each make up more than 6% of the S&P 500, according to Slickcharts.)

“The S&P 500 is the largest 500 firms in the US that are traded on the stock exchanges, and it is well diversified in the sense that it covers all different sectors—utilities, manufacturing, financial, etc.,” said Anoop Rai, a professor of finance at Hofstra University in Hempstead, N.Y. “The key thing to note is if you have money in a diversified portfolio, your chances of losing are very low. Yes, you will have ups and downs, but since 1925, it has constantly gone up.”

This Balanced Approach Reduces the Risk of Losses

Tim Urbanowicz, chief investment strategist at Innovator ETFs, said that the S&P 500 “provides the growth that investors are looking for” and is “very hard to outperform” because it provides exposure to a wide range of companies across various sectors, focusing on their market capitalization.

“The thought process there is the more cash flow they have, the more fundamental value they have, the more exposure that you are getting to those specific companies,” he said. “Naturally, by owning a basket of 500 stocks, if some do well, others do poorly, at the end of the day, you’re in essence reducing the impact of the risk of some of those losses.”

To compare, let’s say you invest $1,000 in the S&P 500 and another $1,000 in a stock of your choice. When you’re investing in a single stock, you’re speculating that the company will perform well in the future. If it doesn’t, you own all the losses. With the S&P 500, those losses would likely be balanced out by stocks in the index that are performing well.

Still, some experts argue that a handful of companies dominating the index makes it less reflective of the broader market’s performance and leaves people open to risk.

Potential Downsides of the S&P 500

While holding the S&P 500 has many advantages, namely that it brings balance to a portfolio, there are potential downsides as well. 

Market-Weighted Index

The makeup of the S&P 500 is based on market capitalization, but the index also uses these numbers to determine how much value each stock has overall in the index. Due to the enormous value of the companies in the Magnificent Seven, they hold significant weight—about a third—in the S&P 500 Index.

“It is on the higher end of what we’ve seen historically,” Urbanowicz said. “Typically, you don’t have that type of concentration at the top.”

Increased Concentration

Because of the heavy presence of the Magnificent Seven in the S&P 500, a small number of companies can have a disproportionate impact on the index’s performance. If these companies have a bad quarter, it could drag the value of the entire index down. That raises the question of whether investors are truly getting the exposure to a wide range of companies that the index promises.

Are These Really Downsides?

Both Urbanowicz and Rai downplayed these potential downsides, however.

Urbanowicz took issue with the fact that the Magnificent Seven isn’t seen as diverse because they are mostly tech companies, arguing that each has a wide array of businesses. Amazon, for example, is known as an ecommerce platform, but also runs Amazon Web Services, a web hosting company, as well as physical retail and a film and TV production arm.

“These are much different companies than we saw 20, 30 years ago, with many different business units internally. That, in essence, helps you diversify some of that risk as well,” he said.

Rai said that the S&P 500 still does offer investors diversification, despite this “new phenomenon” of a small group of companies dominating its value. “Maybe the beneficial effects have slightly been reduced, but overall, to me, it’s the gold standard in terms of holding a well-diversified stock,” he said.

Is It a Good Idea To Invest Only in the S&P 500?

With a diverse range of company stocks dominated by the largest companies in the world, investing in the S&P 500 can be a savvy move. But it shouldn’t be your only investment, according to experts, including Rai and Urbanowicz. One reason is that the index could succumb to losses, which could heavily impact people on the verge of retirement or retirees relying on their portfolios for income.

“There’s always the chance of a world war or a major COVID-type incident that will last,” Rai said, adding that people approaching retirement or current retirees should also have bonds in their portfolio due to their stability.

On the other hand, strictly investing in the S&P 500 will also preclude you from gaining a lot of value from the market. Your portfolio’s value will increase significantly more if you hold Microsoft directly, as opposed to the exposure you get to the tech giant’s stock in the S&P 500 index.

“It cuts both ways,” Urbanowicz said.

Alternative Investments

There are many options when it comes to alternative investments that can complement the S&P 500 in a portfolio.

One of note is the equal-weight S&P 500. As opposed to the market-weighted index, this index spreads your money across the entire S&P 500, as its name suggests. That means you have just as much exposure to the Tinder-owner Match Group as you do to Apple.

“It’s really giving you, in one sense, more diversification,” Urbanowicz said. “You’re spreading the risk and rewards around those same 500 stocks, but you’re just owning more of them.”

Experienced investors often diversify their portfolios with stocks beyond the largest companies, looking to international indexes, emerging market stocks, and mid-cap stocks (companies with market capitalizations between $2 billion and $10 billion) for their potential growth and/or stability. Beyond stocks and bonds, there are non-U.S. equities, credit products, and other diversifying assets, including foreign currencies. 

The Bottom Line

The S&P 500 is an index that provides exposure to the 500 biggest companies by market cap, weighted toward the largest, including Microsoft, Nvidia, and Apple. Due to this, investing in the index could bring diversity to a portfolio, but solely relying on it is riskier than you may think. Investors should hold more and different types of assets to truly enjoy the benefits of a diverse portfolio.