The case against a 100% S&P 500 ETF portfolio

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by etienner

The case against a 100% S&P 500 ETF portfolio

A lot of investors have a 100% S&P 500 portfolio, especially in the United States. Over the long-term, a simple portfolio like the one mentioned above performed greatly over the past 50 years. However, I think it is possible for investors to have a diversified portfolio that has a lot less volatility with a similar (or even better) return. As the Nobel Prize winner Harry Markowitz said: “diversification is the only free lunch in investing”, and I believe it is true.

The assets I will use in the experiment are: US stocks, REITs, Gold, Long Term Treasuries and Small Cap stocks. The reason why I chose these is because they have a negative, low or medium correlation and they have a risk profile similar to stocks, that’s why I did not include Cash or Short Term bonds). Small Cap stocks have a high correlation to US stocks, but they can be used to increase the return of a diversified portfolio (I will come back to this later).

First of all, here is the correlation of all the assets mentioned above since 1994 :

As you can see, except for Small Caps, all of the assets have a low to medium correlation to US stocks. Now, let’s compare US stocks to every asset in this portfolio and see if any of those could be a good addition to an investor’s portfolio.


Here’s what the risk/return profile of gold is compared to stocks since 1972 :

As you can see, gold both has a lower return and a higher volatility, so why would anyone want gold? Due to its low correlation to stocks, holding a small allocation to gold actually increases a portfolio’s return and reduces its volatility when rebalancing annually. In fact, a 80% stocks/20% gold portfolio had a return of 10.60% annually with a 12.97% volatility.

Long Term Treasuries

Long Term Treasuries is the asset with the lowest correlation to US stocks (-0.22), so it is one of the best diversifier an investor could have to reduce volatility. Here’s the risk/return profile for both asset since 1978 :

Long Term Treasuries underperformed Stocks by 2.74% annually. However, its volatility is about 4% lower. So if we add a 20% Long Term Treasuries allocation to a Stock portfolio, what happens to our portfolio’s risk and return?

A 100% Stocks portfolio would have performed better than a diversified portfolio with both Stocks & Long Term Treasuries. In fact, the 100% Stocks portfolio returned 11.43% annually while the 80/20 portfolio returned 11.25%. However, the volatility is much lower for the 80/20 portfolio. It had a 12.41% volatility, while the Stocks portfolio had a 15.16% volatility.


Real Estate Investment Trusts (or REITs) have a medium-high correlation to US stocks (0.57 since 1994) and have a higher risk/return profile. I still included REITs in the analysis, because a small allocation to REITs still decrease a portfolio’s volatility. Here’s the risk/return profile for both assets :

As you can see, REITs both have a higher return and a higher volatility. However, once you combine both assets. The portfolio’s return increases to 9.70% and the volatility decreases to 14.34%. Below is a graph showing the difference in return between both assets (Stocks and REITs) and the diversified portfolio :


Now, there are 3 assets that we know can help reduce a stock portfolio’s volatility and can sometimes even increase its return. But what if we invested in all of the assets mentioned above? For example, what if we had a portfolio that was 20% REITs, 20% Gold, 20% Long Term Treasuries and 40% Stocks?

As you can see, even though the return decreased by 0.38%, the volatility decreased by more than 5.45%. So even if you have high-risk tolerance, it can still be smart to diversify for two main reasons:

  1. The return of your portfolio won’t even be greatly affected in the long run
  2. You can take additional risk elsewhere (e.g. replacing US Stocks by Small Caps, Emerging Markets or Growth Stocks)

At the beginning of this article, I talked about Small Caps and their high correlation to US stocks. Obviously, Small Caps are a poor diversifier, but we can replace US stocks by Small Caps and increase the portfolio’s return. Adding a riskier asset with a high US Stocks correlation will obviously increase the portfolio’s volatility, but it will still be lower than if we had a 100% US stocks portfolio. Below is a table showing the risk/return profile of 4 different diversified portfolios by replacing US stocks for riskier assets :

As you can see, even when we replace US stocks by asset classes with a higher volatility, the portfolio’s volatility is still at least 3% lower than a 100% Stocks portfolio. And when we replace US stocks by Micro Caps or Growth Stocks, the diversified portfolio outperformed a 100% Stocks portfolio with a much lower volatility.

To summarize, the different portfolio allocations mentioned above are the “free lunch” that diversification really is about and it possible to have a lot less volatility without sacrificing any return (we have seen that we can even increase a portfolio’s return with less risk). Obviously, we don’t know what asset class will outperform in the future, but this is only further reason why someone should not only have a S&P 500 ETF in its portfolio.


Disclaimer: Consult your financial professional before making any investment decision.


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