As a financial advisor, I often encounter clients who are attracted to the idea of investing in an index fund — a type of mutual fund or exchange-traded fund that seeks to replicate the performance of a particular market index, such as the S&P 500® Index (which tracks the performance of 500 widely held stocks in the US equity market), or the NASDAQ Composite Index (which is heavily weighted in technology stocks, both inside and outside of the US). But in my view, relying solely on one or more index funds may not always be the best strategy for building long-term wealth. Instead, when working with my clients, I help them discover how a well-diversified portfolio can provide several advantages, including better risk management and more consistent performance across various market conditions.
Let’s explore why a diversified portfolio can be a more prudent choice for many investors.
There are sector and market concentration risks in an index fund
One of the primary disadvantages of relying solely on an index fund is its market concentration. The index is weighted by market capitalization, meaning the largest companies have the most influence on its performance. It’s true that index funds can provide some diversification, but there are drawbacks to these funds. For example, in recent years, investors in S&P 500 Index (“S&P 500”) funds have experienced an over-concentration in the technology sector. In 2023, technology giants like Apple, Microsoft, Amazon, and Google collectively made up over 20% of the S&P 500. While these companies have performed well overall, this level of concentration can expose your portfolio to significant risk if one of these sectors, or even a few key companies, experiences a downturn.
A diversified portfolio, on the other hand, spreads investments across various sectors, asset classes, and geographical regions. This may help reduce the risk that a downturn in one sector will drag down your entire portfolio. Keep in mind, however, that diversification does not guarantee profit or protect against market loss. A diversified portfolio can be tailored to your unique needs, particularly with respect to your objectives (for example, whether you are seeking growth, aggressive growth, or conservation of principal) and your investment time horizon.
How the fees compare
From a pure cost perspective, an index fund can be more cost effective than a diversified portfolio managed by an advisor. One reason is because an index fund’s management fees are ordinarily lower than the advisor fees. This is largely because an index fund seeks to track the performance of its benchmark, making it a “passively managed” investment. This results in lower management fees for the index fund.
While costs are certainly an important consideration in any portfolio, my view is that they should not be the only concern when it comes to choosing the investments that are right for you.
Diversification may provide smoother returns and less volatility
During market downturns, such as the 2008 financial crisis or the 2020 COVID-19 crash, index funds experienced significant losses. For investors nearing retirement or those with a low tolerance for risk, this volatility can be unsettling. In contrast, a diversified portfolio that includes other asset classes — such as bonds, real estate, international stocks, and small-cap value stocks — can help smooth out returns. Bonds, for example, often perform well during stock market downturns, providing somewhat of a cushion when the prices of stocks fall. Similarly, international equities or real estate can offer different growth opportunities that are not as closely correlated with US large-cap stocks. This diversification may help reduce overall portfolio volatility, making the ride potentially much smoother for investors over the long term.
Global exposure may offer diversification benefits
Exposure to investments in more than one country is another factor that’s important in a diversified portfolio. From a geographic perspective, the S&P 500 focuses on US-based companies. Still, it’s important to note that while all S&P 500 companies are domiciled in the US, most are multinational corporations. In fact, only 59% of the revenues of those companies listed in the S&P 500 come from the US.*
Global markets have the potential to offer tremendous growth opportunities. Emerging markets, for instance, often have faster-growing economies and younger populations compared to the US, potentially delivering better returns over certain periods. (“Emerging markets” refers to the economies of those countries that are in the process of transitioning from the “developing” stage of economic growth to the “developed” stage.)
A diversified portfolio that includes international stocks may capture growth opportunities across various global markets. By spreading investments across regions, investors can take advantage of growth in different economic cycles — which may help to lessen the risks associated with a single country’s market underperforming.
Different asset classes provide stability in different market conditions
A portfolio focused solely on a single stock-based index is overweighted in equities, which leaves investors without the benefits of diversification from an asset class perspective, since there are no bond- or stable value-related investments. While stocks do have the potential for high returns, they can also be volatile and prone to sharp declines during economic recessions or bear markets. By diversifying into other asset classes — such as bonds, real estate investment trusts (REITs), or commodities — your portfolio can not only be more diversified, but potentially, more stable.
You only need to look to fairly recent history to see how a diversified portfolio has the potential to be more beneficial for investors:** For example, during the 2008 financial crisis, for the full year, the S&P 500 lost 37.0%, but some bonds performed relatively well, providing a hedge against the falling stock market. For example, European bonds gained 6.9% and global bonds advanced 7.2%. But not all bonds were “equal” that year: High-yield bonds (which can perform in a similar manner as stocks) lost 26.4%, whereas municipal bonds lost 7.4%. Additionally, commodities like gold often perform well during periods of inflation or economic uncertainty.
Choosing a variety of investments allows a diversified portfolio to remain more resilient during challenging economic times, which can help to preserve your wealth.
Risk-adjusted returns may be better in a diversified portfolio
The ultimate goal of any investment strategy is not just to maximize returns, but to do so in a way that aligns with your risk tolerance. A diversified portfolio tends to offer better risk-adjusted returns than an index fund alone. This means that for every unit of risk you take on, you’re more likely to be rewarded with better returns when your investments are spread across a range of asset classes. For instance, a 90/10 portfolio (90% equities and 10% bonds) that includes a mix of small-cap value stocks and global equities may provide higher returns than the S&P 500, for example, while still helping to reduce volatility through exposure to bonds. Even if the nominal return of a diversified portfolio is slightly lower in some years, the potentially smoother ride and reduced risk can help to make this strategy more appealing to many long-term investors.
Why I recommend a diversified portfolio for my clients
Diversifying your investments across different asset classes and regions can help you better protect yourself from market volatility and position yourself for a greater chance of achieving long-term success. While an index fund can serve a purpose as one investment option in your portfolio, I believe it should not be the only one you choose if you are looking to take advantage of the numerous benefits of diversification—including reduced risk, smoother returns, and exposure to global markets.
For a more resilient and balanced approach to investing, I consider implementing diversification as a key strategy to help you achieve your long-term financial goals.
– Jim DesRocher
* Source: FactSet, Revenue Exposure by Country/Region, Apr 26, 2024
** Source: Wang, Penelope; “5 lessons from the crash”; CNN Money; Last Updated: September 10, 2009;
<https://money.cnn.com/2009/09/09/news/economy/financial_crisis.moneymag/index.htm>
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NASDAQ Composite Index is a market value-weighted index that measures all NASDAQ domestic and non-U.S. based common stocks listed on the NASDAQ stock market. Each company’s security affects the index in proportion to its market value.
S&P 500 Index is a market index generally considered representative of the stock market as a whole. The index focuses on the large-cap segment of the U.S. equities market.
Indices are unmanaged, and one cannot invest directly in an index.
Past performance is not a guarantee of future results.
All investments contain risk and may lose value. Past performance does not guarantee future results.
Investing in the bond market is subject to certain risks including market, interest rate, issuer, credit and inflation risk.
Equities may decline in value due to both real and perceived general market, economic and industry conditions.
Investing in securities of smaller companies tends to be more volatile and less liquid than securities of larger companies.
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