Looking beyond the S&P 500: Is your portfolio truly diversified?

Over the past decade, the U.S. stock market has rewarded investors handsomely. In particular, the S&P 500 has delivered exceptional returns, driven largely by a handful of mega cap technology companies. As a result, many investors have come to believe that owning the S&P 500 alone provides all the diversification they need.

As financial advisors, however, we often see a different reality. Many portfolios are heavily concentrated in U.S. large cap equities, whether through index funds, actively managed mutual funds or individual stocks. While these companies have performed exceptionally well, this concentration creates what is known as diversifiable risk.

Diversification remains one of the few free lunches in investing. While it cannot eliminate market risk, it can help reduce the risk associated with relying too heavily on one segment of the market.

The S&P 500 is more concentrated than many investors realize

Many investors think they own 500 equally important companies when they invest in the S&P 500. In reality, the index is weighted by market capitalization, meaning the largest companies receive the largest allocations.

Today, a relatively small number of companies account for a significant percentage of the index. As these companies have grown larger, investors have become increasingly concentrated in just a handful of businesses, often without realizing it.

These are outstanding companies with strong balance sheets and global businesses. However, history has shown that market leadership changes over time. The companies leading today's market are not necessarily the companies that will lead the market over the next decade.

Don't forget mid-cap and small-cap companies

Large companies receive most of the headlines, but they represent only one part of the U.S. economy.

Mid-cap and small-cap companies often provide exposure to businesses that are earlier in their growth cycle and may benefit from different economic trends than large multinational corporations.

Historically, there have been long periods when small and mid-sized companies have outperformed large cap stocks. While they can be more volatile, they may also provide greater long-term growth potential and broaden diversification within a portfolio.

International diversification still matters

Many investors have also reduced or eliminated international exposure after years of U.S. market outperformance.

While the United States has been the strongest-performing major market in recent years, that has not always been the case. Market leadership has historically rotated between countries and regions.

Developed international markets, including Europe, Japan, Canada and Australia, provide exposure to companies operating under different economic environments and monetary policies.

Emerging markets offer another layer of diversification. Countries such as India, Brazil, Mexico and Indonesia continue to experience expanding middle classes, increasing consumer demand and long-term economic growth. While emerging markets carry additional risk, they may also provide opportunities that are difficult to replicate within the United States.

Alternative investments can expand diversification

Diversification extends beyond publicly traded stocks.

Alternative investments have become increasingly accessible to individual investors and may provide return drivers that differ from traditional stocks and bonds.

Examples include:

- Infrastructure investments, such as airports, utilities, pipelines and data centers.

- Commercial and residential real estate.

- Private equity investments in privately owned companies.

- Private credit, where investors provide financing directly to businesses rather than purchasing publicly traded bonds.

These investments may behave differently during various economic environments and can provide additional diversification when appropriately incorporated into a portfolio. They may also generate income streams that differ from those of traditional equity investments.

Of course, alternatives also come with considerations such as reduced liquidity, higher fees and greater complexity. They are not appropriate for every investor, but they can serve an important role within a diversified portfolio.

Bonds Still Have a Place

During periods of strong stock market performance, it is easy to question the role of fixed income.

However, bonds continue to serve several important purposes.

High-quality fixed-income investments may provide:

- Lower portfolio volatility.

- Current income.

- Liquidity for spending needs.

- A potential source of stability during periods of equity market stress.

Rather than simply viewing bonds as return generators, many investors should view them as risk management tools that help balance overall portfolio volatility.

Diversification Is About the Entire Portfolio

One concept we frequently discuss with clients is that diversification should be viewed across the entire household portfolio rather than account by account.

For example, an investor with a moderate risk tolerance might ultimately target a portfolio consisting of 60 percent equities and 40 percent fixed income. That does not necessarily mean every account needs to mirror that allocation.

A Roth IRA may be invested primarily in equities because of its tax-free growth potential, while a Traditional IRA may hold a larger allocation to bonds because interest income is tax deferred inside the account. Taxable accounts may emphasize tax-efficient equity investments, including international stocks that may provide a foreign tax credit.

The objective is not for every account to look identical. The objective is for the combined portfolio to reflect the investor's desired risk profile while being managed in a tax-efficient manner.

Final Thoughts

The S&P 500 has been an outstanding investment over the long term and will likely remain a cornerstone of many portfolios. However, diversification should not end there.

Building a portfolio that includes large-, mid-, and small-cap companies, developed and emerging international markets, fixed income and thoughtfully selected alternative investments can help reduce concentration risk while creating exposure to a broader set of investment opportunities.

No one knows which asset class will lead over the next decade. That is precisely why diversification remains one of the most enduring principles of successful investing. Rather than trying to predict the next market leader, investors are often better served by building a portfolio that is prepared for a variety of market environments.

Reid Schwartz is a columnist for The Item and Co-Founder of Creech Schwartz Wealth Management in Sumter, SC, where he works as a financial advisor helping individuals, families, businesses, and nonprofits plan for long-term financial success.

*Tax and accountancy services are not available through or provided by Creech Schwartz Wealth Management or &Partners, LLC.

This article is for educational purposes only and not to be interpreted as tax or legal advice. Any tax planning strategies discussed by Creech Schwartz Wealth Management will be in conjunction with your tax/legal professional. Past performance is not indicative of future results.

Securities and investment advisory services offered through &Partners, LLC, a broker-dealer and investment adviser registered with the U.S. Securities and Exchange Commission and member FINRA, SIPC.