The Stock Market Is Ultra-Concentrated. Here’s How to Manage the Risks.

Key Concepts

Concentration Risk: The risk that a portfolio's returns are heavily influenced by a small number of assets or a single sector.
Mega Cap Tech Companies: Very large technology companies with significant market capitalization.
Market Cap (Market Capitalization): The total value of a company's outstanding shares of stock.
S&P 500: A stock market index that represents the performance of 500 of the largest publicly traded companies in the United States.
Diversification: A risk management strategy that mixes a wide variety of investments within a portfolio.
Sector Concentration: A situation where a portfolio is heavily weighted towards a specific industry or sector.
Small Cap Exposure: Investment in companies with smaller market capitalizations.
Global Stock Markets: Investments in companies listed on stock exchanges outside of the investor's home country.
Overlap: When different investment funds or strategies hold many of the same underlying securities.
Time Horizon: The length of time an investor expects to hold an investment.
Risk Tolerance: An investor's willingness to accept potential losses in exchange for potential gains.

Concentration Risk in Today's Market

Dominic Pepalardo, Chief Multi-Asset Strategist for Morningstar Wealth, discusses the current trend of market concentration, where a few mega-cap tech companies are driving the majority of stock market returns. This phenomenon, prevalent for the past two years, can significantly boost returns but also introduces substantial downside risks for investors.

Understanding Concentration Risk

Pepalardo defines concentration risk as the situation where the largest companies within stock market indices represent an disproportionately large portion of the index's market capitalization. For instance, in the S&P 500, the top 10 companies currently constitute approximately 40% of the index's total market cap. This means that an investment advertised as diversified may not be as diversified as investors expect.

Drivers of Market Concentration

The current concentration is attributed to the exceptional outperformance of the largest companies, particularly in the technology sector, since the pandemic. As their stock prices have surged, their market value has increased, leading them to occupy a larger share of market indices. Notably, eight out of the top 10 largest companies in the S&P 500 are in technology or technology-related sectors, indicating not only company concentration but also significant sector concentration. While this has benefited investors in the short term, a shift in market sentiment or a downturn in tech stocks could lead to outsized losses for investors.

Historical Context of Market Concentration

Pepalardo notes that market concentration levels fluctuate over time and that the current levels are historically extreme. The previous high for the top 10 companies' share of the S&P 500 was around 25%, compared to the current 40%. There are no immediate signs of this concentration dissipating, and it could potentially increase further.

Factors Leading to Dissipation of Concentration

Historically, two primary factors have led to a decrease in market concentration:

Time: Over time, the composition of the largest companies naturally evolves. Smaller companies grow to become larger, taking spots in the top 10, while existing large companies may shrink and fall out of the top ranks.
Technological Shifts: Major technological advancements can lead to a complete overhaul of the top companies. For example, the tech boom around 1999 saw companies like Cisco rise to prominence, while traditional giants like GE and Eastman Kodak declined and were replaced.

Pepalardo highlights that a decade ago, only four of the current top 10 companies were in the top 10 in 2015. Twenty years ago, only Microsoft remained from the 2005 top 10. This demonstrates significant turnover over longer periods, driven by evolving market dynamics and technological changes.

Concentration Risk for Index Investors

Even investors in broad market index funds face concentration risk. The concern is that outsized moves in a small number of companies or a specific sector can significantly impact portfolio returns. A critical issue identified is the overlap between different index funds. For instance, the top eight names in a broad market S&P 500 fund might be identical to the top eight names in a growth-style index fund. This means investors attempting to diversify by holding funds in different categories may not be achieving true diversification due to the significant presence of these large-cap names across multiple funds. This can lead to unintended sector or company concentration, even when investors believe they are mitigating risk.

Investor Concerns and Diversification Strategies

Many investors are hesitant to abandon the strong performance of their S&P 500 funds, fearing they might miss out on further upside. Pepalardo acknowledges this trade-off between risk and reward. However, he emphasizes the importance of considering diversification to mitigate potential downside risks. Morningstar Wealth recommends diversifying by:

Adding Small Cap Exposure in the US: The top 10 names in the US small-cap index represent only about 6% of the index, offering a much more diversified exposure compared to the S&P 500.
Increasing Exposure to Global Stock Markets: This broadens the investment universe beyond highly concentrated US companies.

These strategies can help investors reduce their exposure to the dominant large-cap tech names.

Balancing Upside and Protection

While it's difficult to predict when the current market concentration will reverse, taking steps to broaden exposure can help reduce downside risk when it does. Pepalardo advises that investors should align their investment decisions with their time horizon and risk tolerance.

Key Takeaway: Awareness

The most crucial takeaway for investors regarding concentration risk is awareness. This involves:

Examining Fund Holdings: Investors should thoroughly understand the underlying assets within the funds they own, especially in accounts like 401(k)s where multiple funds might be held.
Identifying Overlap: Recognizing that different funds may hold many of the same dominant companies is essential to avoid unintended concentration.
Understanding Purpose: Investors should know what each fund is doing for their portfolio and why they own it.

Pepalardo stresses that while he cannot predict market movements, his goal is to raise awareness of these concentration risks, empowering investors to make informed decisions.