Retirement portfolios need diversification as S&P 500 lags 10%

The S&P 500 has returned about 10 percent year to date, trailing the S&P SmallCap 600's 21 percent gain and large-cap value's 16 percent advance.

"Be careful not to performance-chase," said Christine Benz, director of personal finance and retirement planning at Morningstar. "It's a pattern we see so often, where an asset type surges and only then do investors begin to add assets to it. Oftentimes they're too late."

International equities surged 32 percent last year before adding another 13 percent this year. The AI trade now extends well beyond the S&P 500 — small-caps have benefited from AI infrastructure spending, some value indexes hold relatively cheap technology stocks, and emerging markets gain exposure through South Korea and Taiwan's semiconductor manufacturing dominance. Companies of all sizes and geographies would be hurt if and when momentum stalls.

For investors nearing retirement or drawing portfolio income, the biggest risk is an AI-fueled bubble. Defensive sectors such as consumer staples and pharmaceuticals may cushion a selloff, and a cash cushion of up to two years' worth of withdrawals can insulate daily spending from market swings. The latest scorecard matters less for those saving decades from retirement, who have time to weather multiple boom and bust cycles.

Small-Caps Up 21%: Where to Diversify

Investors overweight the S&P 500 should consider selling a portion and diversifying into small- or mid-cap funds, keeping in mind tax consequences in taxable accounts. The SPDR Portfolio S&P 600 Small Cap ETF holds 13 percent in technology, while the iShares Russell Mid-Cap Value ETF has 11 percent. For international exposure, the iShares MSCI EAFE Value ETF offers a 3.5 percent dividend yield driven by financials, consumer staples, healthcare, and energy, with technology at just 4 percent.

IBM's 25 percent one-day collapse — its worst single-day loss on record — served as a warning that even relatively sturdy companies with attractive dividends are vulnerable when AI momentum shifts.

Many investors assume their target-date fund provides adequate diversification, but the actual breakdown can differ from expectations. When checking a fund's holdings, investors should look beyond the headline asset allocation to understand sector concentration, geographic exposure, and market-cap distribution. A fund that appears diversified on the surface may still carry significant technology or AI-related concentration risk.

Target-Date Funds Hold 27% in Tech

Target-date funds handle asset allocation automatically, making them suitable for young investors and those who prefer a hands-off approach. But the lack of customization becomes a problem near retirement, when there's less room for error if markets decline. A typical target-date fund holds a little over 3 percent in small-caps, nearly 14 percent in mid-caps, and 23 percent in non-U.S. equities. Technology exposure at 27 percent sits well below the S&P 500's 47 percent weighting, but investors should evaluate whether their fund's risk profile aligns with their timeline.

Investors should pick a portfolio mix they're comfortable with and stick with it throughout market cycles. With a diversified portfolio, some part of the holdings will perform well in any market environment, eliminating the need to predict which asset class leads next.

This article is for informational purposes only and does not constitute professional advice. Figures cited reflect data available at the time of writing; readers should verify against the latest official announcements.