Most people are told the same thing about investing: buy an index fund, hold it for decades, and you will be fine. For many years this was solid advice. But today, the structure of index funds has changed in a way that creates new and serious risks.
Felix Prehn, former investment banker and founder of Goat Academy, believes every investor should understand these risks before trusting their retirement to “set and forget” index funds.
What Is an Index Fund?
An index fund is an investment that aims to copy the performance of a market index.
For example, funds such as SPY, VOO, and IVV track the S&P 500. The S&P 500 is a list of the 500 largest publicly traded companies in the United States.
The promise sounds simple and safe:
- You get exposure to 500 companies.
- You pay low fees.
- Historically, you might expect around 10% average yearly returns over the long term.
This has been the “gold standard” recommendation for everyday investors. But the reality under the surface is very different from what most people think.
Diversification vs. Concentration: The Magnificent Seven
Diversification means spreading your money across many different investments so that no single company can hurt you too much if it performs badly.
Index funds are sold as diversified. But today they are heavily concentrated in just a few giant companies.
As of late 2025, about 37% of the S&P 500’s value is concentrated in only seven companies, often called the “Magnificent Seven”:
- Apple
- Microsoft
- Nvidia
- Alphabet (Google)
- Amazon
- Meta
- Tesla
These seven companies make up only about 1.4% of the 500 companies in the index, yet they account for more than one‑third of the total weight.
That means if an investor puts $10,000 into an S&P 500 index fund, around $3,500 goes into just those seven tech stocks, and only $6,500 is spread across the other 493 companies.
So instead of broad diversification, the investor is making a huge bet on a small group of tech giants.
How Market Cap Weighting Creates a Dangerous Loop
Most major index funds use something called market cap weighting.
- Market cap (market capitalization) is the total value of a company’s shares in the stock market. It is calculated as share price times number of shares.
- In a market cap weighted index, the bigger the company, the larger its share of the index.
When a company’s stock price rises, its market cap rises, and the index fund must buy more of it. This process is automatic. There is no human deciding, “We own too much Apple” or “We should reduce Nvidia.”
This creates a powerful loop:
- Big tech stocks perform well and their prices rise.
- Their market caps grow, so they become a larger part of the index.
- More money flows into index funds.
- The funds are forced to buy even more of those same big stocks.
- Prices rise further, and their weight in the index grows again.
This self‑reinforcing cycle works very well when markets rise. But the same mechanism can speed up losses when markets fall.
If investors get scared and pull money out of index funds, the funds must sell the largest holdings first. The biggest stocks, which dominate the index, can be hit hardest. In 2022, the top seven tech stocks fell around 41%, while the overall S&P 500 fell about 20%. The concentrated names dropped about twice as much.
Who Really Owns the Stocks in Your Index Fund?
When an investor buys an index fund, they do not directly own the underlying shares. The fund company owns the stocks on their behalf.
Three asset management firms dominate this space:
- BlackRock
- Vanguard
- State Street
Together, they manage over $20 trillion in assets. They are among the top three shareholders in 100% of S&P 500 companies. In about 84% of S&P 500 companies, one or both of them is the single largest shareholder.
Owning 5–8% of a company gives massive influence. These firms can:
- Meet privately with company executives.
- Influence who sits on the board of directors.
- Vote on important company decisions.
Regulators have started to worry that when the same few firms own large stakes across many competitors in the same industry, they might push companies in ways that are not good for consumers or smaller investors.
In one important legal case, U.S. agencies raised concerns that large asset managers may have used their shareholder power to influence how much certain companies produce, affecting prices. This shows that “passive” investors can behave in very active and powerful ways behind the scenes.
For index fund investors, this means something important: by buying the fund, they hand their voting power to these asset managers. The big firms vote on company decisions using the investors’ capital, and not all of those decisions may align with individual investors’ interests.
How Passive Investing Hurts Price Discovery
To understand another hidden risk, it helps to know what price discovery means.
Price discovery is the process in which the market figures out what a stock is truly worth. In a healthy market:
- Many investors study companies.
- They look at profits, growth, debt, and competition.
- Some decide to buy; others decide to sell.
This tug‑of‑war between informed buyers and sellers helps keep prices close to fair value.
But passive investing works differently. Passive funds do not ask, “Is this stock cheap or expensive?” They buy simply because the stock is in the index and in a certain weight. When a stock is added to the index, the funds buy it. If it grows and takes up more space in the index, they buy more.
They are buying blindly, without caring about fundamentals.
When passive investing was small, this did not matter much. There were enough active investors doing detailed research to keep prices in line. But passive investing has grown fast. It has gone from about 19% of fund assets in 2010 to roughly 51% today. More than half of fund assets are now allocated without considering company fundamentals.
Researchers have found that this shift increases market risk. One major effect is higher correlation between stocks.
- Correlation measures how much two investments move together.
- A correlation of 1 means they move in the same direction all the time.
- A correlation near 0 means their movements are independent.
When index funds buy or sell many stocks at once, they push everything in the same direction. Stocks start to move together, regardless of the unique qualities of each business. This reduces the benefit of diversification.
During crises like 2008 or the 2020 COVID crash, this effect becomes even stronger. When many investors rush to sell their index funds at the same time, the funds must sell large baskets of stocks at once. Strong companies and weak companies get sold together, and prices can drop faster than they would in a market driven mostly by thoughtful, stock‑by‑stock decisions.
A useful picture is an overcrowded movie theater. When everything is calm, it feels safe. But if someone yells “fire,” everyone runs to the exits at once. There are not enough doors for an orderly exit, and chaos follows. In markets, rapid outflows from large index funds can create that same rush for the door.
What Can Investors Do to Protect Themselves?
Felix Prehn’s goal is not to scare people away from investing. Index funds have helped millions build wealth, and they may continue to play a role in many portfolios. But blind faith is dangerous. Investors need to understand what they own and the risks that come with it.
Here are some ideas he highlights:
- Check your concentration
Investors should look at how much of their portfolio sits in large U.S. index funds, especially if they are close to retirement. A heavy bet on one country, one index, and seven mega‑cap tech stocks may be riskier than it looks on the surface.
- Understand alternative index structures
There are equal‑weight funds that give each stock the same weight instead of favoring the biggest companies.
These can reduce concentration but may also reduce returns in strong bull markets, because they hold less of the top performers.
- Be careful with “diversifying” into areas you don’t understand
Many people suggest small caps, international stocks, or emerging markets for diversification.
Small caps (smaller companies) can be more sensitive to economic shocks and higher interest rates.
International and emerging markets add currency, political, and regulatory risks.
Investing in areas you don’t understand can increase risk rather than reduce it.
- Consider learning to select individual stocks
For some investors, a path to true diversification may include owning individual companies that are outside the crowded trades of the largest indexes.
These might be solid, less fashionable businesses that receive less attention but still offer strong long‑term potential. This approach, however, requires education, discipline, and a clear process.
Felix Prehn and Goat Academy focus on helping everyday investors understand these deeper dynamics so they can make better decisions. Their work centres on teaching how markets really function, how big players move money, and how to build portfolios that are not just blindly following the crowd.
For readers who want to know more about Felix and his journey from investment banking to teaching, as well as the mission and values behind his educational work, more can be learned on the Felix Prehn Goat Academy page.
The Core Lesson
Concentration risk in index funds is real and higher than during past bubbles. Ownership and influence are concentrated in a few massive firms. Passive flows are changing how prices are set and how stocks move.
Index funds are not “bad,” but they are not the simple, harmless tool many people assume. Understanding how they work is now essential for any serious long‑term investor.
Being informed and educated is the best defense. Blind faith in any single strategy, no matter how popular, can be dangerous—especially when it involves your life savings.