Index funds are low-cost, tax-efficient vehicles suitable for investors with long-term goals, such as retirement and college savings. However, the most popular index funds track the S&P 500, which focuses on large companies. Therefore, adding a small-company index fund can help to balance your portfolio. Indeed, most small-cap index funds held their ground in 2000 and 2001, while S&P 500 funds suffered losses.
Moreover, S&P 500 index funds, as well as total stock market funds, track capitalization-weighted indexes. When stocks increase in price, they make up an ever-increasing portion of a cap-weighted index, so those indexes tend to follow the fortunes of high-priced growth stocks rather than low-priced value stocks.
As a result, such funds are skewed toward growth stocks, especially large-cap growth stocks, because the indexes they track are cap-weighted. For true diversification, you might want to add some value index funds, such as Vanguard Value Index Fund (for large-caps) and Vanguard Small Cap Value Index Fund. The latter, which may truly help to diversify a portfolio, gained 21.9 percent and 13.6 percent in 2000 and 2001, respectively.
For federal employees, the Thrift Savings Plan’s C fund is a large-cap fund while the S fund is a small and mid-cap fund.