Diversification and Constructing Portfolios
As we navigate through volatile markets and evolving economic conditions as well as geopolitical events, understanding the benefits of portfolio diversification can make a significant difference in achieving your financial goals.
The S&P 500 is an index that is made up of 500 stocks. This index is market capitalization weighted, which means stocks with bigger market caps will have a bigger impact on the overall performance of the S&P 500. With this in mind, is owning an S&P 500 ETF or mutual fund really a diversified portfolio?
Currently, the biggest 10 stocks in the S&P 500 make up about 37% of the overall market cap of the S&P 500. This is the largest that has ever been!
Furthermore, everyone is familiar with the “Magnificent 7” stocks (Apple, Alphabet, Amazon, Meta. Microsoft, Nvidia, and Tesla) - these 7 stocks make up about 59.5 % of the total return of the S&P 500
year-to-date.
Chart of Magnificent 7 and S&P 500 Performance
Investors that rely on an S&P 500 ETF or mutual fund may think they are well diversified, but
there is a heavy concentration on a handful of stocks. Also, all of the top stocks are in the
growth/technology sector. Generally, stocks in the same sector trade as a group. So, if the
sector becomes out of favor, most of the stocks in that sector will decline. Individuals that are
adding some of the individual magnificent 7 stocks to their portfolio, are significantly increasing
their concentration, not to mention that a lot of popular growth mutual funds will have these
same stocks as their top holdings as well.
When constructing a portfolio, investors need to be aware of this potential concentration.
Portfolios should be diversified across asset classes, geographic regions, sectors and individual
stocks. This strategy will help lower volatility and avoid large losses and improve long-term
gains in portfolios.
When building a portfolio, it is essential to know what underlying securities are in an index, ETF
or mutual fund that you plan to invest in. This can be found on the mutual fund companies’
website. Take a look at the top sectors and holdings that the fund is invested in and make sure
you are not duplicating exposure when building a diversified portfolio.
