The S&P 500 (^GSPC -0.43%) is just 1.5% away from its all-time high as of this writing. Some investors may be wondering if the index and many top stocks are still worth buying now, or if valuations are getting overextended.
Here are some factors to consider when approaching broad market fluctuations and how the S&P 500 could fit into your portfolio.
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1. Time horizon
One of the most effective ways to compound wealth is through buying and holding shares in quality companies over a long time period. And yet, human nature can make it challenging to buy stocks trading at their all-time high, even though history shows it's often a good idea.
Therefore, one of the most important factors to consider when approaching a red-hot market is your time horizon. A long-term position gives volatility time to play out, whereas a short-term holding is more susceptible to temporary price swings.
Data from MacroMicro shows that the forward price-to-earnings ratio of the S&P 500 is 22.3, higher than the five-year moving average of 20.9 and the one-year average of 20.2. So the broader market, in general, is on the expensive side.
A pricey market is no big deal if you're investing for a retirement that's decades away because the focus is on years of compounding returns rather than what's happening on a quarterly or yearly basis. But if you're investing with a shorter time horizon, valuations will matter more. This is why it's always better to take the pressure off your portfolio by adopting longer-term holding periods.
2. The S&P 500's impact on your portfolio
Buying the S&P 500 provides exposure to 500 of the top U.S. companies. But in reality, it's not as diversified as you many think.
Investing $10,000 in the S&P 500, as represented by the Vanguard S&P 500 ETF (VOO -0.37%), is really $730 in Nvidia, $703 in Microsoft, $583 in Apple, $394 in Amazon, and so on.
The S&P 500 is much more top-heavy today than it was in the past. Not only is half of the index invested in just 25 companies, but the vast majority of the index is concentrated in just a handful of sectors. Technology, communications, and consumer discretionary have a combined 53.3% weighting. So before adding more of your hard-earned savings to the index, it's essential to be comfortable with its composition.
Arguably, the best reason not to buy the S&P 500 at an all-time high is if you're trying to diversify your portfolio but already own a lot of the index's top names. Another reason to avoid the index is if you're trying to invest in mid-cap or small-cap stocks that carry tiny, often negligible weightings in the index (or none at all).
Pairing holdings in individual stocks with positions in ETFs is a great way to adjust your portfolio weightings based on your conviction in certain names.
For example, let's say that you think Advanced Micro Devices is a great buy because it will take market share from Nvidia. The S&P 500 has just a 0.5% weighting in AMD, compared to 7.7% for Nvidia, so buying the S&P 500 effectively doubles down on the very company this hypothetical investor believes can be disrupted. In such a scenario, it makes more sense to invest directly in AMD as a way to counteract Nvidia's outsized representation in an S&P 500 fund.
3. Financial goals
Another good reason not to buy the S&P 500 is if it doesn't align with your investment objectives. The S&P 500 can be an excellent way to compound wealth over time, but it's no longer a good way to generate passive income. The index yields just 1.2% compared to 2.1% about a decade ago. The yield has gone down as valuations have increased, and growth stocks (many of which don't pay dividends or have low yields) have expanded their weightings in the index.
Investors looking to invest in the stock market with an emphasis on passive income may want to consider dividend-paying stocks or ETFs with higher yields.
Coca-Cola has a 3% yield, a track record of earnings growth, and 63 consecutive years of boosting its payout. Buying Coca-Cola and other top dividend stocks offers a way to collect a sizable amount of passive income while still participating in the market, rather than using a passive income strategy that focuses solely on yield with little upside potential.
Only buy the S&P 500 if it works for you
Over time, the best-performing companies are typically those that reinvest the bulk of their excess earnings into the underlying business to accelerate growth. Good ideas combined with deep pockets can create jaw-dropping results, as reflected in the S&P 500's epic long-term gains and shift toward tech-focused companies.
Even near its all-time high valuation, the S&P 500 is still a great buy for most long-term investors. However, it's a mistake to buy the S&P 500 without considering how its composition factors into your existing holdings and investment objectives.
