With an average annualized return of 9.5% per year over the last 90 years, it may seem like a no-brainer for everyone to invest in the S&P 500. However, this isn’t the case. Why do some choose not to invest in the S&P 500?
Not everyone invests in the S&P 500 because they want more annual returns than the S&P 500 index can offer in a year after all fees and commissions are deducted and more investing flexibility. Furthermore, they worry about the heavy impact of tech companies on the index.
The rest of the article will look at these reasons in more detail. By the end of the article, you’ll see if you’re better off sticking to the index or joining other investors to look elsewhere.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
Top 3 Reasons To Avoid Investing in S&P 500
Described below are the top reasons investors avoid S&P 500:
Diversification Concerns With S&P 500
The S&P 500 features 505 businesses from various sectors. Ordinarily, this should mean strong diversification. However, the weighting of the index and its composition means that it’s not the case. Here are a few of these concerns:
Major Stocks Can Heavily Affect the S&P 500
If you already own single stocks in companies like Microsoft, Amazon, or Apple, investing in the S&P 500 will increase your exposure to these stocks. While these companies are healthy, any serious negative impact on their bottom line will likely cause you significant financial problems.
For this situation, your S&P 500 investment will be in the red, at the same time as your direct stock investments in these businesses.
S&P 500 Heavily Exposes Investors to the Tech Sector
The weighting of the S&P 500 is such that only 5 companies make up 23% of the index’s total value. These companies are Apple, Microsoft, Amazon, Facebook, and Google.
So, your investment on the index isn’t anywhere near diversified across the 500+ stocks in the bucket. It means that for every $10,000 you invest on the index, $2,300 is invested on those 5 stocks.
Investors looking for real diversification try to avoid putting the fate of nearly a quarter of their investments in the hands of just 5 companies.
The index is a poor reflection of the U.S. economy due to the weighting applied. At the time of writing, airline stocks account for only 0.18% of the S&P 500. So, in that $10,000 investment, only $180 is invested in that sector. For department stores, it falls to just $1 (0.01% of the index).
Buying the index then is more or less investing in the 4 tech-leaning sectors, which include:
- Software infrastructure
- Internet retailers
- Consumer electronics
- Internet content
The top 10 companies in the above sectors by market capitalization account for the bulk of the S&P 500’s yearly move. So, some people avoid the index because it over-exposes them to the tech industry.
Some Investors Want To Invest in More Asset Classes
Investing in the S&P 500 means you’re expecting the U.S. stock market to be the highest-performing sector each year. However, it has only achieved that feat twice in the last decade.
People ignoring the S&P 500 choose to spread their investment across more asset classes, including foreign stocks, government bonds, and natural resources. Others look at more volatile opportunities, such as angel investing.
There’s No Opportunity for Outsized Returns With S&P 500
As stated earlier, the annualized return on the S&P 500 is 9.5%. Many people don’t find such returns attractive—especially when management fees can lower that return to 6–7%.
Warren Buffet and other billionaires may advise betting 90% of your investment pot on the index because they can afford to. A 6% return on a billion dollars is $60 million.
The typical investor in their 20s will have around $10,000 in investments on average. A $600 return per year won’t look attractive to such individuals. Assuming they choose to put everything on the index.
Investment vehicles that promise 20% and above returns will always look more attractive to young and undercapitalized investors.
It’s no coincidence that many people in this category are dabbling into cryptocurrency and options trading. They’re at the age where getting burned isn’t a disaster compared to undercapitalized investors in their 60s.
Uncoupling the index, choosing the top 10 tech stocks, and spreading investments on them evenly will likely yield more return. Random portfolios of 30 stocks each beat the index 96% of the time in this research.
S&P 500 Lacks Flexibility in the Face of Volatility
When you’re invested in the index, you have to sit through all swings and roundabouts. As the world struggled with the impact of COVID-19, stock indexes like the S&P 500 took a heavy tumble. It went into a drawdown of 33% before rebounding to hit new highs.
An investor that left their investments untouched would’ve missed the opportunity to avoid or take advantage of the downturn and also missed out on riding the drawdown back up after the market recovered.
Active managers would’ve hedged the portfolio, moved it to cash, or sold a part of the investments to buy back the drawdown later.
Should You Avoid the S&P 500 Completely?
With the above reasons why people avoid the S&P 500, it might make sense to you to avoid the index completely. However, that’s not a good idea.
You shouldn’t avoid the S&P 500 completely. However, it shouldn’t hold all your investments in the stock market. It’s best to split the stock side of your investment into 3 and invest 1 part on the index.
The other parts can go to international stocks and vehicles like real estate investment trusts (REITs). Remember, most experts recommend splitting your entire investment pot into stocks and bonds. Your age determines the values allocated to each one.
The rule of the thumb is to subtract your age from 100 to get the percentage of the pot that should go to stocks and then put the remainder in bonds. Bonds usually get the shorter end of the split until you hit 50 years of age and above.
So, if you’re 33 years of age, 67% of your investment sum should go to stocks while 33% goes to bonds. When you’re aged 60 years, 40% of your investments should remain in stocks.
Do Rich People Invest in the S&P 500?
Some rich investors like Warren Buffet choose the S&P 500 as their main investment vehicle. However, many others prefer to stick with investments in their industry while making riskier bets elsewhere for outsized returns.
Steve Balmer is a good example of how a rich person will typically invest. With a net worth of $70 billion, his investment portfolio is heavily tied to Microsoft (300 million shares). He once held a 4% stake in Twitter but sold up in 2018. Presently, he only holds a handful of real estate investments and the ownership of the L.A. Clippers.
So, many rich people will likely ignore the index. However, keep in mind that they can probably afford to do so more than the average investor.
Downsides to Picking a Few Individual Stocks Versus an Index
While you’re likely to make more money by choosing stocks instead of buying the entire index, it’s rarely that straightforward.
First, you have to know how to pick the right stocks. Even if you choose to stick with the top 10 tech companies, you’ll have to factor in the cost of rebalancing the portfolio each year and possible taxes.
If you invest in single stocks and rebalance the portfolio every year, you’ll need to pay capital gains tax every year you sell stocks that yield positive returns. With taxes deducted, your returns will automatically look less attractive.
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Conclusion
People looking for outsized returns and better diversification don’t invest a lot in the S&P 500. However, investors looking for stable returns and those looking to avoid a more hands-on approach with stock selection and portfolio management prefer the S&P 500.
To decide the direction to go, speak with your financial advisor to get an informed opinion on your situation.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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