The S&P 500 Is Hiding a Sneaky Risk. Here’s How Investors Can Prepare for Potential Volatility.

If you’ve been fully invested in the stock market, you should have zero complaints. The S&P 500 index (^GSPC -0.14%) put up a total return of 311% in the past decade (as of Nov. 10). This is the most accessible investment asset class available to the average person. And that kind of performance is encouraging.

But right now, the S&P 500 index carries a risk investors might not be that familiar with. It’s worth taking a look under the hood and paying attention to the details. Here’s what investors need to know. Furthermore, here’s how to prepare for what could be a prolonged period of volatility.

Understand the market’s power law

A power law helps to describe how a small number of variables drive the vast majority of results. This shows up in various fields. It’s also how the stock market works. This same trait defines the S&P 500 index.

On the surface, you might assume the benchmark instantly gives you a diversified portfolio. There are hundreds of large and profitable U.S.-based businesses in the index. Investors do immediately gain exposure to the entire American economy.

This is a capitalization-weighted portfolio, however. This means that companies are grouped by size based on their individual valuations. The most prominent position is Apple, which has a market cap of more than $5 trillion. It represents well over 7% of the S&P 500 index.

Taking this one step further, it shouldn’t be a surprise that the mega-cap technology stocks have a sizable impact on the benchmark’s performance. Concentration is the hidden risk that can’t be ignored.

These companies as a group are spending unprecedented amounts of capital on data centers to power their artificial intelligence goals. Vanguard estimates nearly $1.1 trillion in capital expenditures next year among the five big hyperscalers (Alphabet, Amazon, Meta Platforms, Microsoft, and Oracle). This huge spending increases financial risk and uncertainty about the ultimate payoff, which can boost volatility.

That uncertainty received another jolt after the midterm elections. The Democratic Party won majority control of the Senate and House of Representatives. Investors expect this to lead to closer scrutiny and a potential crackdown on data center development, which could slow the AI boom and, in turn, pressure market sentiment.

Making portfolio moves is an option

I wouldn’t be surprised if many investors have no clue just how much of their financial lives may depend on a small group of tech companies. These enterprises have never been more important to the economy and stock market, so how they perform will impact portfolio returns. Simply knowing the S&P 500 index’s concentrated layout is a critical first step.

It’s also worth understanding the uncertainty that the AI infrastructure build-out presents. The political ramifications of the midterm elections are yet to be determined.

But this shouldn’t really alter the activities of long-term investors who have plenty of time until they reach retirement age. It’s mainly about being prepared mentally and emotionally. These investors will continue to buy and hold through the volatility, a nearly unavoidable aspect of investing in a tech-weighted index.

For investors who want to take tangible action, it may be time to consider the Invesco S&P 500 Equal Weight ETF. Stocks are held equally, and rebalancing happens every quarter. It charges an expense ratio of 0.2%.

Having peace of mind from owning an equal-weighted exchange-traded fund (ETF) comes with a real financial opportunity cost, though. In the past decade, the Invesco S&P 500 Equal Weight ETF generated a total return of 216%. That’s significantly lower than what the Vanguard S&P 500 ETF achieved. Better diversification, a primary goal for some investors, doesn’t always lead to the best outcome.

Neil Patel has positions in Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Oracle, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.