Poor Standard: Why You Should Avoid the S&P 500

It's high time for many index fund investors to move away from the mother of all benchmarks, the S&P 500.

As index funds soared in popularity during the past decade, indexing became nearly synonymous with the S&P 500. That was fine with most investors during the late 1990s, as the S&P 500 posted a five-year string of 30% average annual returns.

However, the S&P 500's performance over the past three years has been abysmal: Since March 31, 2000, the index has lost 39%, according to Lipper. And it still sports a rich trailing price-to-earnings multiple of 30.8. "Large-cap U.S. stocks are still overvalued, and investors have too much exposure to them," says Louis Stanasolovich, founder of Legend Financial Advisors.

The dreary past and outlook for the most popular benchmark has led many individuals and professionals to question the merits of indexing. But as individuals rethink their portfolios, they need to separate the benefits of index fund investing from the continuing trouble signs on the S&P 500 as a benchmark.

"You should not own only the S&P 500 if you want to get exposure to U.S. stocks," said Larry Swedroe, director of research for Buckingham Asset Management and author of Rational Investing in Irrational Times.

Here's the argument for opting out of the S&P 500: The index is too concentrated in big growth companies, too richly valued and too limited in scope to be the appropriate core holding in one's portfolio.

Big Money

The S&P 500, which Standard & Poor's created in 1957, is by far the most widely used benchmark for index fund investors. Of the $364.2 billion in index funds, $196.9 billion, or 54%, is invested in S&P 500 index funds, according to Lipper. That includes the (VFINX Quote)Vanguard 500 Index fund, which with $54.02 billion in assets is the nation's largest stock fund.