You Need to Diversify Beyond the S&P 500
Buying 500 companies in a single country isn’t very diversified at all
Diversification is one of the first principles of portfolio management. Intuitively, we know that putting all of your eggs in one basket carries inherent risk and puts too much of your financial security at the whims of a single company or asset.
One of the more commonly recommended sources for diversification is to buy an index that tracks the S&P 500 due to its reliably strong performance over the past several decades. While this is certainly better than having no diversification at all, it still concentrates assets to large companies in the US. Below are a few reasons why that approach is limiting and does not provide true diversification.
Many large cap stocks have already realized their biggest periods of growth
As a large cap stock in the US can be defined as having a market capitalization value of over $10 billion, it takes explosive growth for any individual company to ever BECOME a large cap stock. While some of these firms have continued their meteoric growth after this point, like Amazon for instance, that is the exception and not the rule.
The statistically likely outcome is that a large cap stock will experience diminishing returns AFTER becoming a large cap stock. This asset class is still very reliable and should be in just about everyone’s portfolio, but placing all of one’s funds in this class provides no exposure to smaller firms who have potential to grow into larger businesses in the future…
Small cap stocks have outperformed large cap over the long term
The S&P 500 has instilled a lot of confidence in investors, and for good reason. Note that in recent years, namely since recovery from the 2008 crash, large cap stocks have outperformed small cap stocks. This has largely been driven by explosive growth from larger players in the tech sector.
However, when extracting performance over a longer period of time from 1972 through 2020, US small cap stocks have outperformed large cap stocks with annualized returns of 11.9% vs 10.8%, respectively. While this 1% difference may seem small, it can amount to considerable totals over time due to compounding.
The same argument for small cap stocks can be applied to international funds
There are some US investors who argue that US diversification is enough because the globalization of the economy over the past several decades has resulted in most leading US companies establishing a global market presence. I know we Americans have a tendency to think of ourselves as the axis in which the world turns, but this frame of thought is a little ridiculous.
It is true that most of the largest firms in the world today are based in the US, but nearly half of the collective market value of the global economy is driven by non-US companies. As of this writing, about 56% of global market value is driven from the US. That’s a huge chunk to be driven by a single nation, but the combined share of other developed and emerging markets is also far too large to ignore.
In addition to the regional share of market value, concentrating funds in any one country over-exposes the investor to the risks of that country. This may include large market swings dictated by tax policy, interest rates, inflation, job creation reports, and elected officials. You don’t want to put all of your eggs in one basket, whether that basket be a single company, asset class, or even the most powerful economic superpower in the world.
Similar to the argument between large cap and small cap, the US has experienced huge growth and will likely continue to do just fine. However, if you want to include portfolio exposure to the NEXT waves of growth, look to where it hasn’t happened yet by including at least some international exposure, especially in emerging markets.
Final thoughts
Diversification is an exercise in minimizing risk while maintaining exposure to upside. Investing in an S&P 500 index is a good but incomplete strategy in accomplishing this. Expect long term growth from areas that haven’t yet experienced it. You may not know exactly where that growth will come from, but if you’ve planted seeds in EVERY farm you can be sure to bear fruit.
As a final thought, just because small cap, international developed markets, and emerging markets pose huge opportunities, that doesn’t mean that any one of those asset classes should dominate your portfolio. The S&P 500 will undoubtedly be worth significantly more 20 years from now than it is today. It deserves a place in your portfolio, perhaps even as the centerpiece, but always make sure you aren’t only expecting growth in places where it has already occurred.
