Perhaps the most common piece of investing advice I see on TikTok, YouTube, Instagram Reels, CNBC articles, or wherever you go to get your short-form, generic finance tips, is:
“Invest in index funds!”
The main reasoning for this guidance is index funds offer a simpler, more diversified investment approach than day trading or picking individual stocks which, as I’ve chronicled in the past, is typically not the best long-term investment strategy for most people.
An index fund is essentially a basket of stocks that mimics the performance of a certain segment of the stock market. Index funds allow investors a low-cost, convenient way to invest in hundreds of different companies within a single investment product.
The most popular index in the world is the S&P 500.
The S&P 500 tracks the performance of the 500 biggest companies in the United States. Whenever you hear someone talk about “the market,” they’re usually referring to the S&P 500.
In fact, the three largest—most amount of money invested in them—index funds in the world all track the U.S. stock market:
- Vanguard Total Stock Market Index Fund (VTSAX)
- Vanguard 500 Index Fund (VFIAX)
- Fidelity 500 Index Fund (FXAIX)
While the United States only makes up about a quarter of the global economic output, the U.S. stock market makes up almost 70% of the worldwide stock market.
Because of the success of the U.S. stock market over the past decade, people are pouring into S&P 500 index funds like never before.
As mentioned above, index funds are touted for their diversification. Instead of buying a single stock, you can buy an S&P 500 fund and spread your risk between 500 stocks.
However, in today’s market environment, I wonder how much diversification the S&P actually provides.
Torsten Slok published a graph that shows the combined weight of stocks with a weight of 3% or more in the S&P 500 index is at an all-time high and continues to rise:
In other words, the S&P 500 is becoming increasingly concentrated in a handful of big companies that dominate the index.
The 10 largest stocks in the S&P 500 now represent nearly 40% of the index:
Additionally, the four largest companies (Apple, Nvidia, Microsoft, and Amazon) make up a whopping 25% of the overall index.
So when buying an S&P 500 fund, yes, you’re getting access to 500 different companies, but in reality, the index’s performance is almost entirely dependent on a few massive tech companies referred to as the “Magnificent Seven”—Apple, Nvidia, Microsoft, Amazon, Meta, Tesla, and Alphabet.
For some perspective, while American stocks have vastly outpaced European stocks since the downturn in 2022, if you simply took Nvidia out of the S&P 500 the entire index would have underperformed Europe’s stock market over that time.
Now, when it comes to investing there are different levels of diversification. Holding multiple stocks is more diversified than holding a single stock. But if you just own Apple, Amazon, Tesla, and Nvidia, you’re not really diversified. All of these stocks are large tech stocks that share similar characteristics and perform similarly to market movements.
Owning hundreds of companies in the form of a mutual or index fund still doesn’t necessarily make you diversified if the underlying stocks are all from a single country or sector.
I’m as big a fan of the United States as anyone; the U.S. stock outperformance is a sign that we have the best economy and innovators in the world. But one of the few dependable features of the stock market is that it’s cyclical. There is no one strategy or segment of the market that works all of the time, and that tends to be something people ignore.
The following chart shows returns for U.S. and foreign stocks by decade:
As you can see, things ebb and flow. There isn’t a single market that outperforms in every decade.
The purpose of diversification is to spread your investments in such a way that you reduce the odds of the worst outcomes while still benefiting from good outcomes.
Being diversified means you’ll miss out on some home runs, but it also means you’ll never strike out, and not striking out is the key to letting the magic of compound interest work in your favor.
“Average returns sustained for an above-average period of time lead to extraordinary results.” — Morgan Housel
Thanks for reading!
Jake Elm, CFP® is a financial advisor at Dentist Advisors. Jake a graduate of Utah Valley University’s nationally ranked Personal Financial Planning program. As a financial advisor at Dentist Advisors, he provides dentists with fiduciary guidance related to investments, debt, savings, taxes, and insurance. Learn more about Jake.</em