The Risks of Overconcentration

The Risks of Overconcentration

June 13, 2023

So far this year in the US markets, there have been a handful of stocks that have driven most of the return. Dave McGarel of First Trust posted in his June 2nd Market Minute, “By almost any account, the S&P 500 Index year-to-date performance has been incredibly narrow and concentrated. Just seven companies account for the entire 10% return. The other 493 companies combined are delivering a slightly negative return. Stunning.”

This great performance of some of the largest US stocks has led to more concentration in the S&P 500. Caitlin McCabe discussed in the Wall Street Journal, “Eight of the largest tech and growth companies in the U.S.—Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Tesla, and Nvidia—now account for 30% of the S&P 500’s market capitalization. That is up from about 22% at the start of the year.”

We have been able to benefit from the strong performance of these large US stocks this year. Some may question whether we should increase our exposure to them even more. We must be careful—we don’t want to be overconcentrated in them, despite them being great businesses. Part of why we believe in diversification is to help mitigate the risks of overconcentration. The old adage: “Don’t put all your eggs in one basket” can apply well to investing.

Another thing to consider is the valuation of these companies, or how much they are worth today based on cash flows, earnings potential, etc. Because it is not easy to value a company or know exactly what it is worth today, many investors may be willing to pay high prices. But at some point, you can pay too much. In a recent Wall Street Journal article, James Mackintosh wrote “What can go wrong for buyers of what are undoubtedly some of the world’s greatest companies? The usual mistake is to overpay…”

A June 5th piece from Hartford Funds pointed out “the S&P 500 Index has a forward price-to-earnings (P/E) ratio of 19. The top 10 stocks are pricier with an average P/E ratio of 31. But the top three stocks? They’ve got a whopping average P/E of 45. (Source: FactSet)”

One way to implement diversification and reduce concentration risk is through using equal-weighted strategies, which we use in addition to market-cap-weighted strategies. Another way is through rebalancing portfolios, which is something we do regularly.

Recent examples of individual stocks, market sectors, investment styles, and funds/ETFs can help us understand the value of diversification and rebalancing (all return data provided is total return, sourced from Morningstar):

Individual Stocks

  • Zoom Video Communications (Ticker: ZM) had a banner year during the Pandemic in 2020 as everyone turned to its platform for work, school, and interaction. The stock returned a whopping 395.77% in 2020. Unfortunately, this great year was followed by two straight years of very large declines: a return of -45.48% in 2021 and -63.17% in 2022!
  • Exxon Mobil (Ticker: XOM) struggled in 2020 with a -35.94% return, significantly underperforming the broader US market. But the stock bounced back strong in the next two years with a return of 56.91% in 2021 and then 86.06% in 2022!
  • The eight aforementioned US companies that have done well so far this year were all down significantly last year, with returns as follows for 2022:
    • Alphabet Class A -39.09%, Amazon -49.62%, Apple -26.32%, Meta -64.22%, Microsoft -27.94%, Netflix -51.05%, Tesla -65.03%, and Nvidia -50.26%

Market Sectors

  • The energy sector of the S&P 500 (which includes Exxon Mobil, Chevron, and ConocoPhillips) struggled in 2020, with a return of -33.68%, which was by far the worst-performing of the 11 sectors in the S&P 500 that year. However, in both 2021 and 2022, it was the top performing of the 11 sectors, posting a return of 54.64% in 2021 and 65.72% in 2022.
  • Conversely, the information technology sector (which includes Microsoft, Apple, and Nvidia) took the cake for the top-performing sector in the S&P 500 in 2020 with a return of 43.89%. But last year (2022), it was one of the worst-performing sectors with a return of -28.19%.

Investment Styles

  • The Russell 1000 Growth Index posted dramatic outperformance relative to the Russell 1000 Value Index in 2020. The Russell 1000 Growth Index had a return of 38.49% in 2020, while the Russell 1000 Value Index was up only 2.80%.
  • In 2022, things changed. The Russell 1000 Growth Index got hit hard, struggling with a return of -29.14%; the Russell 1000 Value held up much better, coming in with a return of -7.54%.

These are just a few examples, and there are many more. However, most things aren’t always this dramatic in their price swings, and reversals aren’t always predictable or inevitable. Yet these examples help illustrate the principle that you don’t want to become too concentrated in one company, sector, or style. Things that can seemingly do no wrong aren’t always bound to continue in the future with what has happened in the past. There is a healthy balance in risk-taking, concentration, and diversification. If you want to discuss more about our approach to these things, please don’t hesitate to contact us!


Important Disclosures

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The opinions expressed in this material do not necessarily reflect the views of LPL Financial.