Large Eggs, Small Eggs: Rising Concentration in Stocks

With all the fun and activity of summer, 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? It is 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 most investors, the U.S. large cap stock markets have become much more concentrated over the last 10 years. The stocks of the top 10 largest companies in the S&P 500 now represent about 1/3 of the index, up from about 14% in 2014.² Also, the impact of tech stocks has greatly increased over that same period. Of the 10 largest companies in the S&P, eight of them are tech companies, up from only two in 2014.⁴ To see the outsized impact such concentration can have, you only have to look at the S&P 500’s +26.3% gain for 2023, of which the “Magnificent 7” stocks — Amazon, Apple, Google, Meta, Microsoft, Nvidia, and Tesla — were responsible for over half of the increase.¹ The 2023 year also supports the premise that concentration can be at least partially attributed to the fundamentals of such companies: the top 10 companies of the S&P, while accounting for 27% of the total market cap of the index at year-end, represented 69% of all the profits earned by those 500 companies during that year. So companies can be highly weighted in an index for good reasons, above-average profits or higher return on equity.

Historically, the U.S. stock markets have traveled this territory before. Similar levels of concentration have been seen occasionally throughout the decades, including the early 1900s, the 1930s, the late 1950s, and the early 1960s.² So while the degree of concentration in the U.S. equity markets today is high compared to its range of the past hundred years, such occasions are rare, not unprecedented. The pace with which concentration has increased over the last ten years, however, is also quite high.³

Why is this important?
Even though above-average stock market returns are associated with periods of rising concentration, it does make the market’s performance much more dependent on only a handful of companies, which has implications for the risk of one’s portfolio.⁵ The last two recent bear market drops, in 2020 and 2022, were both relatively brief and had little impact on the degree of concentration in the U.S. markets. So historically, it might be more accurate to call concentration in stocks a regularly-occurring feature rather than a rare defect.

In fact, of the 10 largest national stock markets worldwide, the U.S. equity market is still the 4th most diversified, with several European and southeast Asian markets even more concentrated in a handful of companies.¹ So while the U.S. stock market has been rapidly becoming more concentrated over the last decade, there are other national markets across the globe even more highly concentrated.

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 a properly diversified portfolio, there is typically a lot of turnover in the top stocks. Since 1950, only a handful of companies have held on to a spot among the S&P 500’s three largest companies for more than a few consecutive years.¹ While a few companies have enjoyed longer streaks of being in the largest three, they are not many, and company size is not the same thing as producing the highest investment returns. What worked best recently does not usually stay the best for long, and investors chasing high return investments typically receive lower actual returns.

Part of being able to set appropriate expectations for ourselves as investors and guarding against particular investment risks is knowing what is going on and having some depth to that knowledge. An understanding of what stock concentration is and its recurring highs and lows over the years is a good step in that direction.

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.

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Sources:

¹ Mauboussin, Michael. Callahan, Dan. “Stock Market Concentration: How Much is Too Much?” Morgan Stanley Investment Management, 4 June 2024.

² Iacurci, Greg. “Is the U.S. Stock Market Too ‘Concentrated’? Here’s What to Know,” CNBC Personal Finance, 1 July 2024.

³ “Stock market concentration is on the rise. Will this continue?” J.P. Morgan Global Research, 15 February 2024.

⁴ Taylor, Dr. Brian. “200 Years of Market Concentration,” Global Financial Data, 22 May 2024.

⁵ McGeever, Jamie. “U.S. stock concentration – it’s not all doom and gloom,” Reuters, 12 June 2024.