How Stock Market Concentration Impacts Investors

The stock market’s strong performance since March has not been shared by all parts of the market. Some sectors, notable technology-driven ones, have fared better than those directly impacted by the pandemic and social distancing.

What’s more, the outsized contribution of tech stocks resulted in a brief period of volatility in September. It’s understandable that this may feel “fragile” and unsustainable to some investors.

The Dominance of a Few Tech Stocks

This concern can be broken down into two separate but related issues. First, the so-called FAANG stocks, along with other large tech companies and more recent IPOs, have significantly outperformed the rest of the stock market both this year and over the past decade.

Many of these companies have benefited from trends in digital transformation, which have only accelerated during the COVID-19 pandemic. Unlike the dot com bubble of the late 1990s and early 2000s, many of these companies have profitable and proven business models.

As a result, the composition of major market indices has shifted over the past decade. The five largest stocks in the S&P 500 are Apple, Amazon, Microsoft, Alphabet (Google), and Facebook. Many sectors are driven by technology stocks, including Information Technology, Communication Services, and Consumer Discretionary.

This is not to say that these stocks will outperform forever, and it’s always the case that past performance is no guarantee of the future. However, the rise in these stocks is a reflection of how the economy looks today – a fact that benefits diversified investors. Investors ought to remain balanced across a variety of sectors and styles that are tied to trends in the underlying economy.

The second issue is that a small group of companies has had an outsized impact on the overall stock market. It’s understandable that this feels untenable for some investors.

Chart: Cumulative returns of the S&P 500 stock market index alongside its equal weight and top 50 stock counterparts. This chart shows that the largest stocks, which have the largest weights within the index, have outperformed this year.

Sources: Clearnomics, Standard & Poor’s

Perhaps the simplest way to see this is to compare the standard S&P 500 index, which places a weight on each stock based on its size or market capitalization, to one which gives an equal weight to each stock. Using market cap weights provides a more accurate sense of the composition of the stock market – i.e. where the dollars are. Using equal weights helps investors to benefit from a broader base of companies.

The Market May Reflect a Changing Economy

Due to the outperformance of large tech stocks, the market cap-weighted S&P 500 has significantly outperformed its equal weight counterpart. This is even more pronounced when looking at only the largest 50 companies in the S&P 500. Over the past two years, the biggest companies have outperformed the overall index by a cumulative 10%.

But once again, this reflects the growing importance of these large companies to the economy and the world over the past decade. In fact, it’s not the case that large companies necessarily dominate stock market returns. For much of the history of the stock market, the largest companies were often seen as the most boring (e.g. “blue chips”) – perhaps serving as a source of stable dividends, but little more. Over the past 15 years, an equal weight index has actually outperformed the market cap-weighted one since it benefits from returns across a wider array of stocks.

The Future is Unpredictable, Stay Diversified

Thus, although mega cap companies have driven overall stock market returns recently, whether this will continue depends on the balance between tech trends and the importance of size/scale to companies. It’s important for long-term investors to remain diversified across many parts of the market to benefit from these economic trends.

This can be achieved through our managed investment account, where we’ll recommend a diversified ETF portfolio that gives you exposure to different markets and regions based on your specific risk preferences.