Many investors think they are diversified if their investments track a broad market index such as the S&P 500. Unfortunately, the way these indexes are constructed can create an unexpected concentration risk—investors own, in effect, very few eggs in a very small basket.
Most indexes are created via a method called “market-cap weighting,” where a company’s “market capitalization” is calculated (the number of shares outstanding for the company multiplied by the current market price for a share), and then the index is structured so that the companies with a higher market cap receive a higher weighting.
The performance of these more heavily-weighted companies then have a greater impact on the performance of the overall index, while companies with a smaller market cap will have less impact. For example, the top five names in the S&P 500 (Apple, Microsoft, Amazon, Facebook, & Alphabet/Google) accounted for most of its returns in 2020.
So what does it mean to say that the current market is heavily concentrated? It means that more and more weighting of the overall index is represented by fewer, bigger, companies. Today, the top 10 companies in the S&P 500 account for almost 1/3 of the overall weight of the index…while the bottom 250 companies represent roughly 10%. This level of extreme concentration is now approaching historic records.
Why does that matter?
Investors are exposed to a greater “concentration risk” then they may be aware of. Having such a high concentration in so few names means that as the share price of those companies increases, not only do they become more expensive, so does that market overall (in a “rising tide lifts all boats” phenomenon). If the price of the top few companies were to suddenly drop, the market would likely also experience a sudden downward shift, and investors would endure heightened volatility…which if they are unprepared for it, can often lead to poor investment decisions out of panic. The solution: don’t rely on a handful of indices, and instead, diversify broadly and globally.