Are You Overdiversified?

I've been shamelessly singing the praises of broad-market index funds, such as those based on the S&P 500, for more than a decade now. After all, lots of reasons to love them:

• They can give you everything a simple investor needs, delivering market-matching returns that beat most other investments over long periods.
• They tend to carry low fees.
• They don't require much time, effort, or investing savvy.
• They offer instant diversification.

Is there any time when it might be a mistake to invest in an S&P 500 index fund? Well, here's one: if you're expecting to become a significant shareholder in lots of exciting companies.

It's true that these funds instantly park you in 500 of America's biggest companies. Put your moola in them, and your fortunes will be tied to those of General Electric (NYSE:GE) and ExxonMobil (NYSE:XOM) -- along with 498 other companies. But let's look at this a little closer. It's not that I don't want you to invest in S&P 500 index funds -- even Warren Buffett has recommended them for most investors. It's just that I want you to understand what you're getting.

Look at the following table, which shows you the weight of various companies in the index.

Let's imagine that you have $5,000 invested in an S&P 500 index fund. How much of your money will be invested in these various companies? Check out the table below:

This information can be surprising to some people. You might feel happy to be a part-owner in a fast-food giant and beam with pride watching Audrey Hepburn in "Breakfast at Tiffany's." But your ownership in both companies combined probably won't cover the cost of dinner and a movie for two, even if dinner is a Big Mac and fries.

Not so bad
That's okay, though, if all you're after is the overall market's return, or close to it. That's what this fund delivers, and it's enough to outperform most mutual funds over long periods, and enough to beat bonds, as well.

Consider also that you might actually have $50,000 or $100,000 invested in the fund -- perhaps via a 401(k) account through your employer. If so, you'd own $1,660 or $3,320 of ExxonMobil stock -- nothing to sneeze at. That's equivalent to roughly 24 or 48 shares. You'd still own tiny sums of many other companies, though, such as $30 or $60 of Tiffany.

What you're after
What matters in this scenario is what you're after. If you want exposure to small-cap companies, you won't find it here. If you want foreign stocks, you're out of luck again. (But if it's global gains you're after, many of these big American companies generate much of their income abroad -- think of ExxonMobil and McDonald's as examples.) If you want a host of undervalued growers in your portfolio, that's problematic, too, because the index doesn't discriminate by value -- it holds undervalued and overvalued companies alike.

Fortunately, you have another option -- you can simply complement your index fund holdings with some carefully selected individual stock holdings of your own -- or with other mutual funds that concentrate their positions into the companies you like the most.

For pointers to some outstanding mutual funds, ones that are long-term outperformers, with talented management and reasonable fees, permit me to recommend our Motley Fool Champion Funds newsletter. It has recommended many such funds -- and its recommendations, on average, are beating their respective benchmarks by over 13 percentage points. (Click here to try it for free for a whole month, which will give you full access to all past issues and all recommended funds.)

And in the meantime, if you're invested in an S&P 500 index fund, spend some time in our Index Fund Center learning what you own. And if you're not yet invested in it, consider doing so -- with eyes open.

Longtime contributor Selena Maranjian owns shares of General Electric and McDonald's. For more about Selena, view her bio and her profile. The Motley Fool is Fools writing for Fools.