Editor’s note: This week, we’re revisiting a timeless lesson from Genia about the pros and cons of passive investing… a critical mistake you might not realize you’re making… and how to easily correct it.
“Don’t look for the needle in the haystack. Just buy the haystack!”
That quote is attributed to John Bogle—one of the most influential people in market history. He created the very first index fund, Vanguard Group, in 1976. Today, Vanguard is the world’s biggest index fund manager.
The quote summarizes Bogle’s approach to investing: Don’t spend time searching for the best of the best… Instead, buy the whole market.
This is index investing (also known as passive investing) in a nutshell. And this simple structure works wonders, especially long-term…
Since Bogle created Vanguard, index investing has become mainstream thanks to its cheap and simple model.
In essence, index funds work by selling losing stocks little by little… and buying more of the winning positions as they keep gaining in market cap. This way, you benefit even more from the winners… and feel less pain from the losers.
But if you’re not careful, it could lead to a major mistake most investors don’t realize they’re making…
You might not be as diversified as you think…
Diversifying is one of the most important ways to reduce your portfolio risk.
But if you invest in the same top mega-cap stocks via funds—whether an index fund… a mutual fund… or your 401(k)—you might not be diversified enough…
You see, the more money that pours into index funds, the more it props up the top stocks—such as Apple (AAPL), Microsoft (MSFT), and Tesla (TSLA)… while distorting the value of other stocks in the market.
As you can see from the chart below, Apple, Microsoft, and Amazon (AMZN)—all great companies—are so big they now account for more than 16% of the S&P 500.
And if you look at the top 10 stocks in the SPDR S&P 500 ETF Trust (SPY)—the index fund tracking the S&P 500—just 2% of index names account for more than a quarter of the fund.
In other words, some 490 stocks in the S&P 500 have much less impact on the index than even one of its top 10 positions.
10 largest stocks in the market
But this works both ways… When Apple declined 18% this year, it dragged the market down disproportionally. The same goes for other top stocks, such as Microsoft, Amazon, Alphabet, Tesla, or NVIDIA.
These stocks are the top members of the “growth” subsection of the market… which, as you can see by the performance of the iShares S&P 500 Growth ETF (IVW) on the chart below, lost some 22% this year.
On the other hand, value stocks—represented on the chart by the iShares S&P 500 Value ETF (IVE)—lost just 5% year to date… dramatically outperforming their “growth” peers.
Not having a wide enough variety in your portfolio means less protection against the downside… and less profit potential outside of the market return.
Fortunately, it’s a simple matter to fix this mistake…
Ensure your portfolio is properly protected
Know your investments—not just what, but also how much…
Inventory your entire portfolio (including the positions in all your funds)… Review your top holdings… Understand why you own your largest positions… And make sure you don’t own more of a single stock than you want to.
Consider diversifying outside of market-leading stocks and sectors.
And if you don’t want to give up on potentially higher returns, there’s nothing wrong with stock picking outside of the usual suspects… having some value plays… or even commodities and precious metals such as gold and silver.
The same goes for value stocks, which tend to be smaller and cheaper than index-leading mega-caps… and which have already outperformed the market this year.
When you diversify and invest in smaller stocks, you’ll position yourself to find the next Microsoft… have higher dividend payouts… and be better protected on the downswing.
P.S. You don’t need to sacrifice growth to find value in these markets…
For my favorite high-yield, high-growth assets to prosper in the current environment…