Why You Shouldn't Double Up

Quick quiz: How many people own an index fund that mirrors the S&P 500?

Good question
While we don't know the exact number, it's probably a lot. Consider: Two funds -- one a mutual fund, one an exchange-traded fund (ETF) -- hold more than $200 billion in assets between them. Vanguard's famous 500 Index Fund sports total assets of $129 billion; its younger cousin, the SPDRs (SPY) ETF, holds $74 billion. By way of a useless comparison, New Zealand's GDP, the world's 53rd largest, is $103 billion.

But this is good. After all, 75% of actively managed mutual funds fail to beat the passive index each year, and the S&P's 10%-or-so historical annual return (with dividends) is pretty easy money. Even better, VFINX and SPY are two excellent low-cost options. So, if you have money invested in one of these vehicles, good for you.

Thanks for the compliment, but so what?
Now take a holistic look at your portfolio. Do you also own shares of Bank of America (NYSE: BAC), Pfizer (NYSE: PFE), or Schlumberger (NYSE: SLB)? If so, you may have unwittingly doubled down on these three market behemoths. That's because these three stocks are among the largest holdings in the Vanguard 500 Index Fund; they account for 3.8% of the fund's net assets. Or what if you hold shares of Cisco Systems, which makes up 1.5% of VFINX? Such concentrations essentially mean you've doubled down on a company, so you'd better be confident in its growth potential.

The point is, if you invest in individual large caps and steer another hefty portion of your savings into the S&P 500, you may be heavily concentrated in one asset class: U.S. large caps. Now ask yourself: Is this the asset-allocation game plan you want?

Livin' large
Don't misunderstand: It's smart to hold dividend-paying large caps. They're steady. They make for smart anchors to your overall portfolio, particularly if you can buy shares at good prices. (Indeed, we both own 3M.) But here's what large-cap stocks aren't: the best-performing stocks on the market.

No, that honor goes to small caps. In our Motley Fool Hidden Gems small-cap investing service, we define small caps as companies capitalized at less than $2 billion. There are only eight small caps in the S&P 500, and these stocks compose less than 1% of Vanguard 500's holdings. That's right: less than 1%. Included in that list are former mid caps that have been hit hard in 2007: E*Trade (Nasdaq: ETFC), Jones Apparel (NYSE: JNY), and Unisys (NYSE: UIS), each of which is down 30% or more year to date.

Add some spice
Even within the most conservative asset-allocation plan, there's room for more than just 0.09% of small-cap exposure -- be it 10%, 20%, or even 50%. (It depends on your investment timeline and risk tolerance.) That's because while small caps can be volatile, the returns will help you beat the market over the long term and maximize your savings, particularly if you can pick promising small caps.

That last goal is the mission of Hidden Gems. Boiled down, our methodology is simple: Fool co-founder Tom Gardner and Bill Mann start with the more than 3,000 small caps on the major exchanges, and they find the best ones by blending qualitative and quantitative research. The results? Since inception, the service is beating the S&P 500 by 30 percentage points on average. That kind of kick is worth adding to your index fund. Click here to learn more about a free trial.

This article was originally published on Aug. 24, 2006. It has been updated.

Tim Hanson and Brian Richards construct their portfolios like they would a Nintendo Ice Hockey team. Tim owns shares of 3M. Brian owns shares of 3M and VFINX. 3M and Pfizer are Inside Value choices. Bank of America is an Income Investor selection. The Fool's disclosure policy floats like a butterfly and stings like a bee.