Concentration risk is the investing equivalent of ‘putting all your eggs in one basket’, it is the risk of holding a portfolio tilted heavily towards certain assets, sectors or countries. It can lead to wilder swings in returns compared to a more diversified approach.
Perhaps the first piece of advice investors receive in their journey is to construct a balanced portfolio which will provide smoother long-term returns, but this has become increasingly trickier than it seems.
Whether you have hand picked stocks or even invested in a broad index your portfolio is likely suffering from an increasing amount of concentration risk.
Is the S&P 500 diversified?
Well, not really… since it is a market capitalisation weighted index, larger companies have a heavier impact on the index performance (as opposed to an equal weight index, where all companies have the same impact on performance). So, perhaps unintuitively, the go-to index for passive investors of 500 US stocks suffers from significant concentration risk.
The rise of the ‘Magnificent Seven’ has been well documented and they now make up one third of the index collectively. In fact, they have contributed more than half of the index’s returns in the first half of the year.
What does this mean in reality?
To highlight the risk here, borrowing our earlier analogy, those seven eggs are much larger, taking up a significant amount of space in the basket and will heavily dictate our portfolio outcome if their bull run ends and they underperform.
For example, if you remove NVIDIA the remaining six stocks struggled to keep pace with the S&P 500 in the first half of the year, and with wilder swings.
In fact, the average annualised volatility of these 7 stocks is almost triple that of the S&P 500 index, resulting in bigger deviations in performance. It would be prudent to consider supplementing your portfolio with an S&P 500 ETF that is equal-weighted, included in all our flagship Core portfolios, which reduces this concentration risk.
There’s a whole world out there
Diversification can take many forms, whilst the S&P 500 represents more than 80% of total US equity market capitalisation, it represents only 48% of the world equity market. That is a lot of exposure we are missing out on, so diversifying geographically with investments in other developed and developing markets is important.
Similarly, we should diversify into other asset classes. Bonds have one of the most favourable entry points in recent times with yields at 15-year highs given the current interest rate environment.
Commodities are also an important pillar of a diverse portfolio. Gold in particular, often used as a defensive asset before a market downturn would help reduce volatility.
Ritesh Ganeriwal, our Managing Director of Investment & Advisory, recently shared his insights with CNA Money Mind on how the Mag 7 Companies are shaping market dynamics, their current valuations, concentration risks, and strategies for diversification beyond traditional indices.
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