The S&P 500 index has made a notable recovery since its April decline, regaining strength and restoring investor optimism. But while the rebound might appear encouraging, financial experts are cautioning against putting too much faith — or money — into a single index dominated by large-cap companies. After all, the S&P 500 represents roughly 80% of the U.S. stock market’s total capitalization, and that kind of concentration brings risks that can’t be ignored.

Lisa Shalett, Chief Investment Officer at Morgan Stanley Wealth Management, warns that investors should think carefully before relying solely on the S&P 500 for short-term returns. “For people evaluating their performance over a one- or three-year horizon, we don’t believe the ‘set it and forget it’ S&P 500-only strategy is the right approach,” she said.

That doesn’t mean long-term index investing — the type famously supported by Warren Buffett and Vanguard founder Jack Bogle — has lost its value. Shalett acknowledged that for those who place their money in an S&P 500 fund within their 401(k) and leave it untouched for decades, the approach still makes sense. However, she emphasized that most investors don’t behave that way.

“Humans are naturally loss-averse and tend to check their portfolios frequently,” she noted. “That makes it incredibly hard not to intervene for 30 years. That’s just not how most people actually invest.”

A Concentration Problem: Tech and AI Dominate

Another issue with an S&P 500-focused strategy today is the overwhelming influence of a handful of technology companies. In the second quarter, overall profits and margins for the index expanded, yet much of that growth was driven by the so-called “Magnificent Seven” — Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla. These seven giants accounted for 26% of total earnings growth, while the remaining 493 companies saw profits increase by just 3%.

“That’s not a healthy market,” Shalett said. “It’s a very narrow one.”

John Mullen, Managing Director and President at Parsons Capital Management, pointed out how the index’s composition has evolved. “What you’re buying in the S&P 500 today is not the same as what you were buying a decade ago,” he said. The top 10 holdings now make up nearly 40% of the index. “So when you invest in the S&P 500, you’re essentially investing in these 10 names — and, more specifically, you’re investing in technology and artificial intelligence,” he explained.

Among the top companies, only Berkshire Hathaway stands apart as a non-tech player, Mullen noted.

The Role of Generative AI

According to Shalett, the market’s biggest tech names have already priced in much of the potential impact of generative AI — “we’re in the sixth or seventh inning of that story,” she said. That’s why Morgan Stanley is now searching for opportunities in sectors that can still experience meaningful productivity gains from AI, such as financial services, healthcare, and business operations.

“We’d rather focus on areas where the benefits of generative AI could deliver upside surprises,” Shalett said, adding that the firm encourages its clients to be more active in stock selection rather than relying solely on passive index strategies.

She also pointed to Berkshire Hathaway’s recent $1.6 billion investment in health insurer UnitedHealth as an example of how AI could reshape even traditionally bureaucratic industries. “The insurance sector is highly manual and ripe for transformation,” she said. “This move shows confidence in AI’s ability to improve margins and efficiency.”

Why Diversification Still Matters

Despite the dominance of megacap stocks, diversification remains crucial. Joseph Veranth, Chief Investment Officer at Dana Investment Advisors — ranked fourth on CNBC’s 2024 Financial Advisor 100 list — said that many investors’ portfolios have become increasingly concentrated as the largest companies in the S&P 500 have outperformed. “Unless you’ve been rebalancing, your exposure to those top names has grown significantly,” he said.

To mitigate risk, Veranth and other experts recommend rebalancing portfolios to include smaller-cap stocks or different sectors. Shalett echoed this advice, urging investors to explore international and emerging markets for potential growth.

One straightforward diversification option, according to Mullen, is the S&P 500 Equal Weight Index, where each company is represented equally. “It’s the simplest way to spread your exposure,” he said. Investors might also consider factor ETFs that cap company weightings or emphasize specific industries, as well as indexes such as the Russell 1000, which tracks the top 1,000 companies in the Russell 3000 universe.

In short, while the S&P 500 remains a pillar of the U.S. stock market, investors should recognize its growing concentration and tech-heavy bias. The index’s recent rebound might be promising, but sustainable, balanced growth will likely come from diversification — across sectors, company sizes, and even borders.