Warren Buffett once famously said that, for most investors, the best investment strategy is to own an S&P 500 index fund. But what did he really mean by this? Should investors focus solely on the S&P 500, or does this advice conflict with the widely accepted financial principle that suggests diversifying your investments for greater stability and return potential?
What is the S&P 500 Index?
The S&P 500 is a market capitalization-weighted index that tracks the performance of 500 of the largest publicly traded companies in the United States. It serves as a critical benchmark for the U.S. stock market and is widely considered one of the best representations of U.S. equities.
In a market-capitalization-weighted index, stocks are weighted according to their total market value, which is calculated by multiplying the share price by the number of outstanding shares. As a result, larger companies have a greater influence on the index’s performance than smaller companies.
Though you can’t directly invest in the S&P 500 index, you can gain exposure by investing in mutual funds or exchange-traded funds (ETFs), which track the index.
Advantages of Investing in the S&P 500:
1. Broad Exposure to U.S. companies: One of the biggest advantages of investing in S&P 500 index funds is the broad exposure they offer across multiple industries. These funds provide access to sectors such as information technology, financials, healthcare, energy, and more.
2. Low-Cost Investment: The S&P 500 has grown in popularity over the years, partly due to its accessibility and low cost. ETFs and mutual funds that track the S&P 500 often come with minimal fees, especially compared to actively managed funds, making them highly attractive to investors. Moreover, the index is rebalanced quarterly to reflect market changes accurately. Investors holding a mutual fund or an ETF that tracks the S&P 500 enjoy the convenience of fully automated management, eliminating the need to rebalance or replace the underlying securities manually.
3. Strong Historical Performance: Since its inception in 1957 through 2024, the S&P 500 has delivered an impressive annualized return of 10.67% (in U.S. dollars). Many proponents of the index argue that professional fund managers – despite charging higher fees – often fail to outperform the index over time.
The Limitations of the S&P 500:
While investing in the S&P 500 index has its advantages, it’s essential to be aware of the potential risks and limitations associated with this investment strategy.
1. Lack of True Diversification: Although the S&P 500 offers a range of industries, it’s still entirely U.S.-focused. This makes investors vulnerable to U.S. economic downturns and fluctuations in the U.S. dollar.
Additionally, the index includes only stocks; it doesn’t offer diversification across different asset classes, such as bonds, or commodities. According to Modern Portfolio Theory, developed by Nobel laureate Harry Markowitz, true diversification requires spreading your investment across asset classes and geographies. For Markowitz, the most effective way to minimize risk is by constructing a portfolio of negatively correlated assets, meaning they behave differently from one another.
2. Concentration in a Few Companies: The performance of the index is heavily influenced by the top weighted companies and sectors within the index. As of the end of 2024, the top ten companies made up 38% of the index, compared to the 23% that the top ten companies represented at the end of 2000 during the tech bubble.
The most heavily weighted sector in the index, information technology, accounted for 32% of the total index at the end of 2024, compared to 21% at the close of 2000.
Because the S&P 500 is market-cap-weighted, as individual companies grow in size, their weight in the index increases accordingly. If even a handful of these dominant companies or sectors underperform, they can drag down the overall performance of the index more than investors might expect.
While the S&P 500 Index offers a compelling, low-cost investment with a strong historical track record – especially for those seeking broad exposure to U.S. equities – it may not be all you need for a truly resilient portfolio. To better manage risk and growth potential, incorporating international equities, bonds, and other asset classes can help build a more balanced and adaptable investment strategy.
