SPY - S&P 500: Why Diversification Has Become Ever More Critical

2024-06-20 12:14:01 ET

Summary

• On the surface, diversification appears to be well-understood and broadly accepted as good practice by the investment community. In practice, however, diversification is rarely taken seriously, even by professional investors.
• Investor psychology works against diversification by anchoring investors' perception of success with big winners while downplaying or underappreciating the importance of risk management.
• With U.S. equity market concentration reaching extremes last seen in the 1960s, investing in the SPX no longer satisfies the objective of achieving adequate diversification for passive investors.
• One simple solution that allows investors to quickly diversify is to switch from the SPX to an equal-weighted index like the Invesco S&P 500 Equal Weight ETF.
• The other solution is to diversify by investing selectively using the Select Sector SPDR ETFs, which could be a huge advantage to investors who prefer a more active investment approach.

Investors often describe a love-hate relationship with diversification. Some suspect it is a bad idea but do it anyway. Some express regret for over-diversifying and not maximizing gains on the big winners. Some believe it is fundamental to good investing and practice it diligently. Others completely ignore it until it is too late.

On the surface, diversification appears to be well-understood and broadly accepted as good practice by the investment community. Indeed, portfolio diversification is foundational material that is taught and reinforced early on in undergraduate courses on investment topics. In practice, however, diversification is rarely taken seriously, even by professional investors. How often do portfolio managers get fired for failing to adequately diversify? And when was the last time a portfolio manager was paid a huge bonus for good risk management?...

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