There is no denying it, the US market has done very well as of late. However, a look behind the headline figures shows us things aren’t so simple. It can be seen that much of the US market’s strong returns can largely be explained by just a handful of companies. Over the last few years, these company have dominated media attention.

Certain tech mega-companies have certainly posted some impressive returns over recent years. The press has also been especially enthralled with their impressive market capitalisation figures. For example, the current market cap of Apple, was over $3.36 trillion at the time of writing. For comparison, the UK’s entire GDP in 2023 was just under $3 trillion.

First, the 4 FANG stocks (Facebook/Meta, Amazon, Netflix and Google/Alphabet) were the hot companies in the press. Apple was added in 2017 to create FAANG.

By mid-2023 the FAANG acronym was forgotten and ‘the Magnificent Seven’ were the new talking point. A classic bit of industry sleight of hand meant that Netflix was suddenly forgotten, whereas Tesla and Nvidia were the new favourites. Ironically, at the time of writing, Netflix has performed better than 5 of the Magnificent 7 since it dropped out of the ‘in-group’ in June 2023. Newly added Tesla on the other hand has performed the worst, being the only stock to have fallen in value.

Figure 1: the returns of popular tech stocks since the ‘Magnificent Seven’ were coined (Jul 1^st 2023-Aug 13^th 2024)

Feeling the FOMO?

Over recent years, return-focused investors may have looked at the coverage of US markets and wondered whether they should own more in the US, or even of the few stocks that have appeared so dominant of late.

Fear of missing out (FOMO) is a powerful feeling, yet acting on this is a form of recency bias. Extrapolating what has just happened into the future is not sound logic. This is especially true with investing, where unseen forces and new information can have huge impacts almost overnight. While it’s true that the US, largely led by ‘megacap’ tech companies, has delivered impressive returns over the past few years, there is no way of knowing whether this trend will continue.

Bubbles do happen, and can come down hard. We have seen it before with the dot-com bubble at the turn of the century. If investments are too concentrated this carries a huge risk. The upside can be intoxicating, but a fall in value can seriously impact an investor’s financial future. Since June, the returns of many of these large tech firms have faltered; the recent star, NVIDIA has fallen more then most. Whether this continues remains to be seen.

Although the US market dominates via market cap as well as attention, purely return focused investors should, to be consistent in their logic, be eyeing the Danish stock market. This has outperformed the US over the past 20 years, by around 5% per annum on average, driven largely by one stock – Novo Nordisk, which is 60% of the market.

Minimising regret

More risk-focused investors might be becoming a bit concerned by rising company concentrations in their portfolios. When a few companies make up a large and growing proportion of a portfolio, the risk of either absolute failure or simply future underperformance is not appealing. Not doing something about this could quite conceivably become a source of both concern and ultimately regret. 

A simple, systematic way to help with this conundrum is to own a portfolio that is exceptionally well diversified. This means investing in a variety of markets, sectors, capitalisations (mega to small companies). Tilting towards value-oriented stocks has also been shown to be beneficial for long term returns.

A few years ago at BpH, we switched our model portfolios from a UK-biased portfolio to a more unbiased worldwide-allocation. This has not only improved projections of our risk-adjusted returns over the long term, but has made a material difference to our clients’ returns since the transition was enacted. UK markets have lagged behind world markets in recent years. Removal of UK bias has meant exchanging a portion of currently underperforming UK assets and investing more in high performers like the US. This has benefitted returns while sticking systematically to the principle of diversification.

Under the bonnet

Different ways of gauging diversification at the stock level provides insight into the portfolio construction choices on offer.  The outputs below look at the stock concentration of funds that a) track the US equity market using the S&P 500 index b) track the developed markets (DM) by way of the MSCI World Index and c) provide globally diversified exposure to developed and emerging markets (EM) with tilts towards mid-cap and smaller companies, and value stocks[1].

Table 1: Portfolio weightings of Top 10 companies compared

The first point of note is the difference in the total number of stocks in each portfolio.  It is evident that the US market is highly concentrated; over a third of the market is made up of just ten companies (left column). 

Spreading a portfolio into other developed markets (middle column) improves diversification. Around one quarter of the portfolio made up of the ten largest companies, whereas diversifying into emerging markets and spreading out some of the allocation across smaller companies and value stocks (which have higher expected returns over the long term) provides material diversification (right column).

Expanding this analysis in the chart below, it is evident that the top 500 holdings in each of the three options represent from 100% of the portfolio in the case of US equities to only 50% of the diversified global equity option.

Figure 2: Comparing how much of the portfolio the Top 500 companies represent

One final, slightly more technical, measure of diversification is the number of ‘effective holdings in the portfolio. This borrows a type of analysis by bodies which measure market competition and monopolisation. The ‘effective’ holdings is an estimate of the number of stocks that effectively represent the portfolio.  It does not imply that the rest of the stocks are redundant – far from it – simply that they are dominated by the major stocks held.

Table 2: Effective stock holdings

Many investors would feel far more comfortable with 479 stocks dominating the portfolio than just 60. Diversification matters because investors own portfolios today for the future. Given that markets do a pretty good job of incorporating information into prices, we have no forward-looking insight into which company’s shares are going to outperform.  We can avoid both FOMO and regret by walking a sensible path by owning a well-diversified portfolio. 

Risk warnings

This article is distributed for educational purposes for UK residents. It should not be considered investment advice, an offer of any security for sale nor a recommendation of any particular security, strategy, platform or investment product. This article contains the opinions of the author but not necessarily the Firm. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

Use of Morningstar Direct© and FE analytics data

The information contained herein: (1) is proprietary to Morningstar, or FE analytics as applicable and/or their content providers; (2) may not be copied, adapted or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar, FE analytics nor their content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction.

[1]     Funds used a) iShares Core S&P 500 ETF USD Acc b) iShares MSCI World ETF USD Dist. c) Dimensional World Equity GBP Dist.  For illustration and educational purposes only.  These are not recommendations of any kind.  See Endnotes.

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