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  • Writer's pictureJeran Van Alfen, CFP®

Diversification: Why there’s more to your portfolio than the S&P 500

Many times, when we hear references to “the market” or “the stock market” people are talking about the S&P 500. This index has become the standard measure for US investors for how stocks are performing. So, when the S&P 500 is doing well, we often feel good about our investment portfolios and vice versa, if the S&P 500 is down this usually leads us to believe that our stocks are down. However, upon closer examination, you may find that your stock portfolio is performing differently than the S&P 500. This scenario often leads to the question, why don’t we just invest in the S&P? Here are some important points to consider:

What is the S&P 500?

The Standard & Poor’s 500 is an index that tracks the performance of the largest 500 US stocks by market capitalization. Market Capitalization or “Market Cap” is the total value of a public company’s outstanding shares. Here is how market cap is broken down:

  • Large Cap: Value > $10 Billion

  • Mid Cap: Value between $2 Billion and $10 Billion

  • Small Cap: Value between $300 million and $2 Billion

Recently Large Caps have outperformed.

Over the last 10 years, Large Cap US Stocks have been the place to be. This slide below shows the performance of equity market cap classes going back to 2013. As you can see, the performance of Large Cap Growth stocks has dominated while small cap stocks have been the lowest performers. Going beyond performance, this chart also shows that large companies had the least volatility (lowest risk measure) among the various market caps. This makes a strong case for the S&P 500.

Source: JP Morgan GTM Q2 2023. 5.31.2023. JP Morgan Asset Management

Taking a longer view:

When we go back a bit longer (like back to 1925), we find that small companies have produced a performance premium. This point has been studied extensively and was most notably referenced in the Nobel Prize winning research by Fama and French. The chart below shows the performance of asset classes over time and illustrates this outperformance by small cap stocks.

While past performance is not an indicator of future results, this history would lead us to consider that a diversification of equities beyond the largest 500 companies could lead to favorable performance.

Understanding what is driving performance:

To understand the recent outperformance of Large-cap companies, it may be helpful to understand the characteristics of these companies.

Source: JP Morgan GTM Q2 2023. 5.31.2023. JP Morgan Asset Management

As you can see large cap indexes are composed of a much greater percentage of technology and communication services companies, while small cap indexes are more heavily weighted with health care, financials, industrials, and real estate. It is also helpful to recognize that most large cap companies are global and are less directly impacted by the US economic cycle, while small cap companies are usually heavily dependent on how the US economy is functioning.

The last decade has been a digital transformation lead by software, hardware, chips and communication platforms. This transformation has been global in scale and has impacted every industry with enhancements to efficiency. Large cap companies have led this transformation.

Investing in innovation:

As investors, it is important to remember that companies don’t typically start out valued at over $10 billion. Investing in small companies gives us the opportunity to grow with a company. Consider this quote: “What, then, is a sensible way of structuring an allocation to small-cap stocks? The first thing to realize is that the size premium is more or less driven by stock migration—stocks that move across market capitalization portfolios from one period to the next. The size premium is primarily driven by the positive performance of a subset of small-cap stocks that unpredictably moves to the mid- or large-cap space from one period to the next.”[1]

Let’s take Tesla for example. Currently Tesla is #9 in the S&P 500. It’s been a strong driver of recent performance. Here is a chart that shows Tesla’s path to their current size in the market:

Tesla first hit the market in 2010 and made large cap status in May of 2013.

This is an example of a small cap stock that quickly made it big. However, most small companies don’t have these results. It has been found that the key to small company performance is profitability. Companies with high profitability will typically grow and migrate or find a position of industry dominance at their scale.

What it all means for a portfolio:

When building a portfolio, our first and most important rule is that we want to be paid for taking risk. Modern Portfolio Theory has led us to develop an efficient frontier for investing, represented by the chart below. This line shows the combination of investments that indicate higher returns for the least amount of risk.

As we examine the correlation of different asset classes, we have found that combining diversified asset classes such as small cap stocks, foreign stocks, real estate, and commodities can lead to lower volatility and higher expected returns.

Putting it all together

It is important to review your portfolio allocation with respect to your financial objectives. While diversification can lead to a lower-risk, higher-performing portfolio over time, it can also lead to a portfolio lagging in the short-term when compared to a specific, singular asset-class.

Your benchmark should be your financial plan. This should determine the amount of risk that is acceptable to take and the rate of return that you need to capture over time. A well-constructed portfolio should match up to your objectives. Remember, “Invest with Purpose!” This means to know why you own what you own and be intentional with the investments that you make.

Centered Financial, LLC is a registered investment adviser offering advisory services in the State of California, Utah, Texas and in other jurisdictions where exempted. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques, strategies, or investments discussed are suitable for all investors or will yield positive outcomes. To determine which strategies or investment(s) may be appropriate for you, consult your financial adviser prior to investing. Any discussion of strategies related to tax or legal planning is general and is not intended as tax or legal advice. Please consult appropriate tax and legal professionals for recommendations pertaining to your specific situation.


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