Key Points

The S&P 500 index continues to reach historic highs. For investors holding exposure to this large-cap index, this translates to substantial returns. However, experts maintain that the best strategy to prepare for potential interruptions in the index's upward momentum remains portfolio diversification.

The S&P 500 index closed at a historic high on Monday and continued climbing in early Tuesday trading.

While "S&P 500 reaches new highs" has become routine news, some investors remain concerned: is a pullback imminent?

"The diversification function of the S&P 500 index has become ineffective," said Michael DeMassa, founder of Forza Wealth Management in Sarasota, Florida, who is both a Certified Financial Planner (CFP) and Chartered Financial Analyst (CFA).

DeMassa noted that many investors believe investing in the S&P 500 index through funds with ETF symbols SPY, VOO, or IVV equates to achieving investment diversification.

However, he stated this sense of security is merely an illusion – because the S&P 500 index uses market capitalization weighting, meaning that if heavily weighted companies underperform, they could drag down the entire index fund's performance. Additionally, the index's high concentration in the technology sector could cause volatility to spread throughout the entire index.

Deva Panambur, founder of Sarsi LLC in West New York, New Jersey, and both a Certified Financial Planner and Chartered Financial Analyst, believes that investors who can invest long-term in the S&P 500 index will likely achieve decent returns.

But he also pointed out that the S&P 500 index occasionally experiences extended periods of poor performance. For example, between 2000 and 2008, the index declined by more than 30%.

Wall Street analysts generally predict that the S&P 500 index will continue rising in the foreseeable future.

Even so, experts still emphasize that choosing a broader investment portfolio remains the best option to prepare for potential pullbacks.

Experts: Other Funds Can Provide Broader Investment Exposure

Brendan McCann, assistant fund research analyst at Morningstar, stated that for investors seeking a simple investment approach, choosing total market index funds rather than S&P 500 index funds might be a more reasonable choice.

Unlike S&P 500 index funds, total market index funds cover small-cap and mid-cap stocks in addition to large-cap stocks, providing investors with more comprehensive market exposure.

Additionally, McCann noted that investors can also expand the coverage of S&P 500 index funds in their existing portfolios through other methods, such as choosing funds that track "total market indices excluding S&P 500 components" or investing in the Vanguard Extended Market ETF.

McCann emphasized that the key to this strategy lies in "allocating these funds in reasonable proportions."

McCann stated that for investors who don't want to adjust asset allocation long-term, purchasing total market index funds might be a better choice. He further noted that for investors who don't need to worry about the tax implications of fund conversions (such as 401(k) retirement plan investors), the appeal of transitioning to total market index fund strategies is particularly prominent.

Other experts suggest choosing "equal-weight S&P 500 index funds" – these funds hold equal proportions of each component stock in the index. However, McCann cautioned that this strategy has one drawback: trading costs may be higher during fund rebalancing.

Beware of Additional Risks from Overlapping Fund Holdings

Panambur stated that during the S&P 500 index's declining returns from 2002 to 2009, small-cap stocks, value stocks, international assets, and even bonds all outperformed the index.

Today, when constructing investment portfolios for clients, he allocates assets in these areas.

"When planning overall asset allocation, my goal is to ensure the portfolio is more balanced than the S&P 500 index," Panambur said.

The S&P 500 index "buy and hold" strategy was originally intended to provide investors with broad market exposure. "But the situation is different now," DeMassa stated.

DeMassa emphasized that when seeking diversified allocation, investors must pay attention to the specific holdings of each fund they own.

For example, if an investment portfolio simultaneously holds "funds tracking the S&P 500 index" and "funds tracking the Vanguard Growth Index," then the portfolio's exposure to "large-cap technology stocks" would be "further expanded" rather than "limited."