Sticking solely with what you know isn’t always the best idea when it comes to the stock market.
The S&P 500 is filled with companies you probably interact with daily, from big tech like Apple to food and retail companies like McDonald's and Estee Lauder. The index couldn’t be stopped in 2020, ending with a 16.3% gain for the year. While it might be tempting to fill your portfolio with these names you recognize, it can also be dangerous to exclude everything else.
Ignoring smaller companies or those in foreign countries limits your potential gains. It also puts all your eggs in one basket, something financial advisors are constantly warning us not to do.
If you want to invest in the companies that you know and maybe even love, that’s fine. Just make sure you’re not overdoing it.
Know your weaknesses
Successful investors understand that they’re human, and recognize that their emotions might take part in their decision making, says Mark Connely, a certified financial planner and financial advisor with Wealth Design Group and Park Avenue Securities in Houston. So try to recognize your biases.
Do you feel comfortable investing in the S&P 500 because you constantly hear it mentioned in the news? Are you more inclined to pour money into a company you use all the time? Investors can have familiarity bias, meaning they want to say in their comfort zone.
“Look at a list of international small companies, much less a list of U.S. small companies,” Connely says. “You’re going to be like, ‘I have no idea what those companies do. Why would I buy them?'"
There’s also the fact that buying shares of the S&P 500 is the thing to do right now, and the index has been hitting record highs.
There’s also recency bias. Before last year’s impressive returns, the index saw a 29% return in 2019. Investors want in because they think blockbuster returns are the new normal. But that's not necessarily true. Between 1995 and 1999, the S&P 500 saw returns of 20% or more each year before dropping into the negative in 2000.
“The question that everyone has to ask themselves is ‘do we really believe that all economic principles have gone out the window?'” Connely says.
It’s possible you don’t even know that you’re loading up on the S&P 500. Many people aren’t actually going out and buying the S&P 500 index, but those stocks are in most of the mainstream mutual funds offered in 401(k) plans, Connely says. Make sure to diversify across all your investment vehicles, like your IRAs and brokerage accounts, if you have them.
You may also have an overly simplistic approach to diversification, which could eventually spell doom and gloom for your portfolio. For example, if you put some dollars into the S&P 500 index fund and also choose a few individual U.S. large cap companies to invest in, that’s not proper diversification, says Edward Moyzes, wealth management advisor with Strategic View Advisors, an affiliate of Northwestern Mutual, in Manhattan Beach, Calif.
How to diversify
There will always be one area of the market that is doing well while others aren’t, but those areas will flip flop, and we can't predict when that will happen. A diversified portfolio includes assets that don’t correlate, so you can usually benefit in any market environment.
Yes, stocks in the S&P 500 index certainly have a place in a diversified portfolio. But just a few big technology companies — Apple, Amazon, Facebook, Netflix and Alphabet (Google’s parent company) make up around 17% of the S&P 500, according to S&P Global. So it’s important to diversify within equities so you’re also investing in international and small companies, for example. Morningstar typically recommends an international weighting of around 25% of total assets for those with longer time horizons.
Your portfolio should also include diversity across asset classes besides equities, such as bonds, since they perform differently than stocks. For example, last March, when COVID-19 hit the U.S. and stocks plummeted, Treasury bonds held their ground.
The exact breakdown of a portfolio will be very specific to each investor's financial situation, goals and proximity to retirement. For those 10 or more years out from retirement, some experts like 85% to 95% in stocks and 10% to 15% in bonds, with that dropping to 70% stocks and 30% bonds for those between five and 10 years out from retirement and to 60% in stocks and 40% in bonds for those who are retired or within five years of retiring, Money has previously reported.
Diversification is especially important to those nearing or in retirement. If the tides turn and large-cap U.S. stocks start to underperform, those investors may be forced to sell in a down market for retirement income. Some experts prefer a more conservative approach than the one above, with 30% or less in equities when you’re within 10 years of retirement, and reducing that as you get closer.
The upshot: having a diversified portfolio — and not just investing in companies you know — means you don’t need to predict the future.
“There are two types of people in this world when it comes to investing,” Moyzes says. “Those that don’t know what the market’s going to do in the short term and those that don’t know that they don’t know what the market’s going to do in the short term.”