Managing S&P 500 Investment Risks: Strategies You Need to Know

The S&P 500, or Standard & Poor’s 500, comprises around 500 of the U.S.’s largest publicly traded companies and has historically delivered strong long-term returns. 

Investing in the S&P 500, as a proxy for the market, feels like betting on the U.S. to win. But like any investment, the S&P 500 isn’t all growth and no groans. 

Investors hoping to include the S&P 500 in their portfolios should learn the risks of the S&P 500, such as concentration and valuation risk, and what strategies can minimize that risk while still harnessing the S&P 500’s power in their portfolios. 

Understanding the S&P 500

The S&P 500 is an index that tracks the performance of approximately 500 of the U.S.’s largest publicly traded companies. The companies in the S&P 500 span market sectors such as technology, consumer staples, health care, and financials. Together, these companies make up about 80% of the total value of all U.S. stocks, making the S&P 500 synonymous with “market” and the proxy report card for how the entire U.S. market is doing.

There is one caveat, however, to making market assumptions based solely on the S&P 500. Larger companies have more influence over the market’s returns. If a few large companies are doing well, the market will look like it’s booming, even if smaller companies are riding the returns struggle bus. 

Key Risks of Investing in the S&P 500

The returns of the S&P 500 are hard to beat even by seasoned professionals. This makes investing in ETFs or mutual funds that track the S&P 500 tracking ETFs or mutual index funds an attractive option for many investors. 

However, no investment is without risks, and the S&P 500 has its fair share of vulnerabilities that can upset the apple cart, especially in the short term.

Here are some key risks of investing in the S&P 500 that investors should consider before entering the market:

Concentration Risk

The S&P 500 includes company stocks from all major market sectors, but larger companies have more impact on S&P 500 returns. Currently, the S&P 500 has mega-cap tech stocks, commonly called “Magnificent Seven,” driving a significant portion of the index’s performance. A rising tide lifts all boats, where the tech companies and the S&P 500 are concerned. 

Unfortunately, the reverse is true as well: stumbles in the technology sector can cause the whole market to fall. The weight of stocks in this sector and its disproportionate effect on the overall market introduces concentration risk for investors without assets outside the index.

Volatility and Market Cycles

The S&P 500 has a strong growth history, but the growth is not linear, and the market is immune to market downturns. Think of market performance like a bouncing ball while walking upstairs. Will the ball end up much higher eventually? Sure. But getting to the top is full of ups and downs. 

The S&P 500 has endured its fair share of bear markets and corrections since it started tracking 500 stocks in 1957. Even the steadiest investors with a firm understanding of market cycles can get shaken up by nasty bear markets like the 51.9% drop over 1.1 years from 2007-2009. 

Valuation Risks

Bull runs can lead to periods of high optimism where investors flood the market to chase potential earnings. Price, impacted by supply and demand, may reach unsustainable levels during periods with a high volume of trading activity, creating valuation risk. If conditions change, like interest rate hikes or disappointing earnings, the overinflated stock prices deflate quickly when demand tapers.

Economic and Geopolitical Factors

The S&P 500 is very sensitive to economic and geopolitical factors because, no matter the strength of the underlying companies, they do not exist in a bubble. Valuation comes from profits, stock prices, and future outlooks. 

The market hates uncertainty. Rising interest rates, inflation, global conflicts, recessions, tariffs, shrinking GDP, or the threat of these events can depress share prices.  

Historical Performance and Lessons Learned

The S&P 500, representing the broader U.S. market, has a history of long-term growth, but it has not always been a smooth ride for investors to the top. 

The S&P 500 averages a bear market, where stock prices decline 20% or more, once every six to 10 years. These major downturns can spook investor confidence in the short term. However, investors with time on their side can ride out short-term losses for long-term gains.   

Major Downturns

The S&P 500 endured 22 bear markets since 1928, but most investors probably remember just a few.

Most remember the dotcom bubble bursting, sending the S&P 500 tumbling nearly 50%. In this instance, investor enthusiasm and market demand drove prices for these newfangled internet startups beyond sustainable levels. The prices held on for a while until the mild recession and the aftermath of the 9/11 attacks, which caused contracted prices and tech-heavy investors to suffer the consequences of valuation and diversification risk.

Investors probably also remember one of American history’s steepest and severest bear markets. In the Global Financial Crisis of 2007-2009, the S&P 500 fell more than 55%. This financial collapse, triggered by overvaluation and subprime lending in the U.S. housing market, lit a match that burned much of the global economy because foreign banks had large holdings of U.S. mortgage-backed securities. 

Recovery Patterns

Despite the impact of market downturns, the S&P 500 has a strong track record of recovery. It may not be fast, but we all remember the fable of the tortoise and the hare.

After the dotcom crash, the market took nearly seven years to recover fully, and the recovery was followed almost immediately by the Great Recession. Thankfully, the 2008 bear market recovery took only four years.

The cyclical nature of market rise and fall highlights some important lessons for investors. Those who remained cool, calm, and collected despite economic or geopolitical shockwaves to the S&P 500 were often rewarded in the long run as markets recovered. The S&P 500’s turbulent history confirms that investors with a long-term investing mindset, diversification, and emotional regulation reap rewards. 

Strategies To Manage Risks

There are some time-tested strategies investors can use to mitigate risks associated with the S&P 500 while keeping it a core asset in their portfolio.

Diversification

Don’t put all your eggs in one index. The S&P 500 includes a diverse range of sectors, but it still concentrates heavily on large and mega-cap stocks. The history of market cycles shows us that even with a solid track record of growth, only investing in the S&P 500 through ETFs or mutual index funds is risky. 

Investors can reduce that risk by investing in assets like small-cap funds, international stocks, real estate, alternative investments, or fixed income investments like bonds and certificates of deposit.

Risk Assessment and Tolerance

Just because you know what goes up must come down, doesn’t mean you’re prepared to wait out the drop. Investment success is not just picking shooting star assets; it’s also about feeling comfortable and confident in your decisions when your shooting stars start to fade. 

Consider consulting a financial advisor or using online risk tolerance questionnaires to determine your capacity for risk. This can help you decide how much of your portfolio belongs in the S&P 500 and other assets.

Long-Term Investment Approach

The S&P has had some fantastic gains and terrible losses over the years, but has an average growth of 10% yearly since the index expanded to 500 stocks in 1957. That 10% annual return doesn’t come from trying to time the market perfectly; it comes from getting in and staying in it. 

A long-term investment strategy works for equity investments because, with time on your side, you have time for your portfolio to recover from inevitable market downturns.

Regular Portfolio Rebalancing

Regular portfolio rebalancing is an important risk mitigation strategy because some assets may grow faster than others, which can throw off your target allocation. Rebalancing at regular intervals ensures that your portfolio remains aligned with your risk tolerance, goals, and timeline. 

The Bottom Line

Investments tracking the S&P 500 offer investors broad exposure to 500 of the U.S.’s largest publicly traded companies. Even though the S&P 500 has a history of strong performance, it is not risk-free. 

To make good decisions, investors must understand the risks of investing in the S&P 500, like its concentration in big tech, valuation concerns, and volatility. If you choose to add ETFs or mutual funds that track the S&P 500 to your portfolio, you can manage these risks by diversification, regular portfolio rebalancing, and aligning investments with your risk tolerance, timeline, and goals.