Index funds are the darlings of passive investing. They promise broad market exposure, low fees, and no need for constant stock-picking headaches.

But here’s the problem: Most people think they’re getting diversified exposure when, in reality, they’re placing oversized bets on a handful of massive companies.

Take the S&P 500, for example. It’s an index of 500 companies, so it must be evenly distributed, right?

Wrong. The top 10 companies alone make up over 30% of the index. That means if Apple, Microsoft, or NVIDIA take a hit, your supposedly diversified portfolio is taking that same hit—hard.

Market-Cap Weighting Can Skew Your Investments

Most index funds weight their holdings by market capitalization. That means bigger companies hold more influence over fund performance.

The higher a company’s stock price climbs, the more weight it takes in the index. This creates a snowball effect: Strong stocks get even more fund inflows, while weaker (but potentially undervalued) companies get left behind.

The problem? This works great in bull markets, but when the top dogs start to fall, they drag the entire index down with them.

Look no further than 2000 when the dot-com bubble burst—companies like Cisco and Intel were the market darlings of their time, only to see their valuations crater when the hype ended.

Investors who thought they were “diversified” quickly learned that their portfolios were overly reliant on tech stocks.

Running the Numbers on Market Concentration

Let’s run some numbers to see why market-cap weighting creates risk.

Say you invest $10,000 in an S&P 500 index fund. With the top 10 companies making up roughly 30% of the index, you’ve essentially put $3,000 of your money into just 10 stocks.

That leaves $7,000 to be spread across the other 490 companies. And it’s even worse when you consider that the bottom 250 stocks combined make up less than 10% of the index.

So much for balanced investing.

Now, compare that to an equal-weighted index fund, where each company gets the same allocation.

That means instead of having 30% of your portfolio concentrated in just 10 names, that money gets spread evenly across all 500 stocks.

If one of the giants stumbles, it won’t tank your portfolio.

Adjusting Your Portfolio to Reduce Risk

Market-cap weighting isn’t inherently bad—it just comes with concentration risk that most investors don’t realize.

The good news? You don’t have to ditch index investing to fix the problem. You just need to be strategic about how you diversify.

One way to avoid over-reliance on a few stocks is to consider equal-weight index funds. Instead of being top-heavy, these funds give equal exposure to all stocks in the index, providing a more balanced approach. 

This means that no single stock can dominate your returns, reducing the risk that a sharp decline in one sector or company will drag down your entire portfolio.

Another method is adding mid- and small-cap funds to your portfolio. The S&P 500 focuses on large-cap stocks, but incorporating mid- and small-cap index funds ensures you’re not missing out on high-growth potential companies that aren’t yet giants. 

Historically, small-cap stocks have outperformed large caps over long periods, though they come with more volatility. 

For example, from 1926 to 2020, small-cap stocks returned an average of 11.9% annually compared to 10.2% for large-cap stocks. 

That additional return potential can make a big difference over decades of compounding.

Looking beyond U.S. markets can also help. Most U.S. index funds are heavily concentrated in American tech and finance stocks. International index funds can provide true diversification by spreading exposure across different economies and industries. 

Emerging markets, for instance, have historically offered higher growth rates than developed markets, and including an international index fund allows you to benefit from trends and economic cycles that are independent of the U.S. market. If the S&P 500 struggles but international markets are thriving, having global exposure can help balance your overall returns.

Additionally, sector diversification is crucial. Even within the S&P 500, there are sector-specific ETFs that allow investors to adjust their exposure. For instance, if tech stocks have grown to an uncomfortably large portion of your portfolio, you could add funds that focus on defensive sectors like consumer staples, healthcare, or utilities. These sectors tend to perform well in economic downturns, providing stability when high-growth tech names falter.

Rebalancing your portfolio periodically is another key step. Market fluctuations can throw off your asset allocation over time. If one sector or stock grows disproportionately large in your holdings, trimming those gains and reallocating into underrepresented areas can help maintain balance. Many financial advisors suggest rebalancing at least once a year or whenever any one investment strays more than 5% from your target allocation.

Diversification is more than just holding a large number of stocks—it’s about understanding how those investments interact with one another. By strategically spreading your investments across different weighting methods, market caps, geographies, and sectors, you can build a portfolio that is more resilient to market downturns and better positioned for long-term growth.

Market-cap weighting isn’t inherently bad—it just comes with concentration risk that most investors don’t realize.

The good news? You don’t have to ditch index investing to fix the problem. You just need to be strategic about how you diversify.

One way to avoid over-reliance on a few stocks is to consider equal-weight index funds.

Instead of being top-heavy, these funds give equal exposure to all stocks in the index, providing a more balanced approach.

Another method is adding mid- and small-cap funds to your portfolio.