With all the fun and activity that comes with various seasons, it can be hard for investors to maintain their concentration. The stock market, though, has been picking up that slack for some time now.
Peaking under the hood of the U.S. stock markets, we see them attaining a degree of concentration not seen for many years. This “concentration” refers to the outsized influence that a few stocks have on stock market indices, because of how the indices are put together. Fundamentally, you can think of concentration as the opposite of diversification. While an index may appear diversified on the surface, in reality it may be substantially skewed toward a handful of companies or a particular sector.
So how does market concentration work? Learn more.
With all the fun and activity that comes with certain seasons, it can be hard for investors to maintain their concentration. The stock market, though, has been picking up that slack for some time now. Peeking under the hood of the U.S. stock markets, we see them attaining a degree of concentration that has been historically uncommon. This “concentration” refers to the outsized influence that a few stocks have on stock market indices, because of how the indices are constructed. Fundamentally, you can think of concentration as the opposite of diversification. While an index may appear diversified on the surface, in reality it may be substantially skewed toward a handful of companies or a particular sector.
So how does market concentration work? It’s one of those subtle market nuances that can have a big impact. The S&P 500 index, for instance, is market cap-weighted, which means that the larger companies in the index have a bigger “weight” or influence on how the index performs, and the smaller companies have less. The Dow Jones Industrial Average, as another example, is price-weighted, meaning that the highest priced stocks have a greater impact on the index’s performance. So all the companies constituting the index in question influence the index’s performance, but the performance of some can far outweigh the impact of many others.
By contrast, if an index were equal-weighted, there would be no concentration at all because every stock would have an equal impact on the index’s performance. If the S&P 500 were equal-weighted, for example, every stock in it would have a 1/500th or 0.20% weighting, which means each individual stock has a negligible effect on performance and no more impact than any other. While there are some ETFs (exchange-traded funds) that track an equal-weighted version of a stock index, the indexes typically reported in the news or financial websites are market cap- or price-weighted.
So what’s the issue?
The issue is that, unbeknownst to many investors, the U.S. large cap stock markets have become increasingly concentrated in recent years. The stocks of the top 10 largest companies in the S&P 500 now represent roughly one-third of the index, a substantial increase from earlier periods. Also, the influence of tech stocks has grown significantly. A majority of the largest companies in the S&P 500 are now in the tech sector. In a recent example, a large share of the S&P 500’s annual gain was attributed to a small group of companies often referred to as the “Magnificent 7” — Amazon, Apple, Google, Meta, Microsoft, Nvidia, and Tesla — which contributed a disproportionate share of the index’s performance. These companies not only carry high market valuations but also generate a significant share of the index’s total profits, helping explain their weight within the index.
Historically, the U.S. stock markets have traveled this territory before. Similar levels of concentration have occurred throughout different decades, including the early 1900s, the 1930s, and the mid-20th century. So while the current degree of concentration is high relative to much of the past century, it is not without precedent. What has stood out in more recent times is the pace at which this concentration has increased.
Why is this important?
Even though above-average stock market returns are often associated with periods of rising concentration, it does make the market’s performance much more dependent on just a handful of companies, which has implications for the risk level of one’s portfolio. In past bear markets, concentration remained relatively unaffected, suggesting it is a persistent feature of the market rather than an anomaly.
In fact, among the world’s largest national stock markets, the U.S. remains among the more diversified. Several other developed and emerging markets are even more concentrated, with a few dominant companies accounting for an even greater share of total market capitalization.
So what are the implications of these things for investors?
First, concentration can represent a stealthy loss of diversification in a portfolio, which leads to increased risk. It is not so much having all one’s eggs in one basket as having a few very large eggs and a multitude of very tiny eggs in that basket. A dozen tiny eggs could go bad before you would start to notice or care, but if even one of the large ones gets cracked…it matters. There are only a few of them, and they represent a lot of the egg in your basket. At the least, we can say that concentration is a sword that cuts both directions for investors: it can result in higher returns as well as sharper pullbacks.
Second, while it can be tempting to load up on the biggest stocks instead of maintaining a properly diversified portfolio, there is typically a lot of turnover in the top ranks. Over the long run, very few companies maintain a dominant position in the index’s top three for more than a few consecutive years. While some companies may enjoy longer runs of dominance, it’s not common — and being one of the largest doesn’t necessarily mean it delivers the best returns. What worked best recently does not usually stay the best for long, and investors chasing high-return investments typically end up with lower actual returns.
Part of setting appropriate expectations as investors — and managing risk effectively — is understanding what’s happening in the markets and having context for those trends. An awareness of stock market concentration, along with its recurring cycles and historical precedent, is a valuable step in building that understanding.
The McKinley Carter Advisory Team is available to help you navigate the markets and provide guidance for your investment porfolio. Reach out today and start the conversation.