Benchmark Envy in Highly Concentrated Markets

Benchmark Envy in Highly Concentrated Markets

By: Anthony Criscuolo, CFP®, EA

Holding five hundred stocks seems like good diversification – well not always…

The S&P 500 is the best-known equity index in the world. It is made up of the largest 500 companies in the United States, operating in all different industries and segments of the market. While the companies are headquartered in the U.S., most have substantial global footprints with operations, supply chains, and customers around the globe (some even have operations in outer space). It is seemingly a truly diversified index worthy of the envy of every investor around the world. However, when you look under the hood, it is not a particularly good index – at least not right now.

Highly Concentrated: Under the Hood of the S&P 500

As we pass the halfway point of 2024 the S&P 500 is actually a heavily concentrated, growth-focused, tech-heavy, mega-cap index. The top ten companies make up about 35% of the overall index weighting, with the top 30 companies making up over 50%.¹ The index now has three companies each with a market value above $3 trillion (with a “T”).¹ The $9.7 trillion combined market value of these three largest companies (Microsoft, Nvidia, and Apple) is now more than the combined market value of the bottom 350 stocks in the index. That’s hard to believe so let’s say it another way: just three companies are worth more than the combined value of 350 other companies within the S&P 500—these include some well-known, large, global companies such as 3M, AIG, Hilton, GM, Ford, and 345 others. The S&P 500 has become a measuring stick for Microsoft, Nvidia, and Apple, and a few other large tech names, like Amazon, Meta, and Google. It’s concentrated, and it’s concentrated in tech companies with historically lofty valuations – this makes it risky.

You can see this concentration in recent returns as well. The S&P 500 headline year-to-date return through June 30, 2024, is 15%.¹ This is based on the market-cap weighted returns of the index, which means those biggest companies at the top (especially the big three stocks who are part of the “3T”-club) have an outsized impact on returns. In fact, just one stock, Nvidia, is up over 150% so far this year and has contributed around 30% of the S&P 500’s total return year-to-date, and just five stocks account for more than half of the index’s total return for the first half of the year. If you look at the equally weighted index of the S&P 500 where all 500 companies have the same equal weighting, the year-to-date return is only about 5%. This tells you the breadth of the market rally is not widespread, but rather concentrated and led by only a few names at the top of the index. This concentrated performance was a similar story in 2023, which means the concentration is only getting worse as we continue through 2024.

This, of course, is not the first time (nor will it be the last) we have seen a heavily concentrated market in the U.S. Go back 25 years, in June 1999 near the peak of the Dot Com Bubble, the 30 largest S&P 500 stocks made up about 42% of the index.¹ Most alarming is the fact that just 10 of the 30 largest stocks now were also in the top 30 back then (see chart below).¹ Market concentration does not last forever, and neither do some of the biggest companies contributing to the concentration.

The main reason for the concentration today is investor optimism over Artificial Intelligence (AI) and the hope these large tech companies will make huge new profits from AI products and services. The problem is, even if AI is the future, it does not necessarily follow that these companies are good investments. There is no such thing as a good stock or a bad stock, only expensive and cheap. The price you pay for an investment will have a major impact on the return you receive. The high valuations for these tech stocks are based on the market’s expectation of perfection—clear sailing with easy earnings growth for years into the future.

The future is anything but certain and it’s hard to determine just how future earnings from AI are being factored into today’s stock values. Much of AI is still in its early development and how to monetize it is still unclear, and how governments will regulate it is unknowable. Not to mention new competition and fast-moving advancements in technology are difficult to forecast. In summary, valuations are high, expectations are even higher, and the future is highly uncertain – three factors that suggest a highly risky investment.

A Better Approach: Diversification & Planning vs. Prediction

Good portfolio construction should focus on substantial diversification, long-term total return growth, and risk management. Despite highly concentrated markets, this does not mean you want to avoid all exposure to the mega-cap tech stocks that are currently leading the way. These stocks should still be part of a diversified portfolio, you just don’t want them to become too large of an allocation—you want to maintain balance and proper risk management. When building a diversified portfolio, you should focus on investing in different asset classes which provide pure exposure to different segments of the markets, which can be based on size, style, and geography. In the long-term markets move in cycles, so do individual asset classes.

By its nature, a diversified strategy will underperform the S&P 500 or some other market benchmark over certain periods, and particularly during periods of extremely concentrated markets like the present. However, this is not a flaw of a diversified strategy, rather it is a feature. Being diversified means avoiding a heavily concentrated portfolio, especially to a few companies in a similar segment of the market all surging based on a singular overall theme – in this case exuberant optimism over the future of AI. You should actually want and expect your diversified portfolio to underperform during periods of such extreme market concentration. You also want to look for opportunities in the market for out-of-favor asset classes with more attractive valuations, such as international stocks or small-cap stocks.

Any attempt to time the markets, or heavily concentrating a portfolio by trying to pick only the few winning stocks or asset classes is a fool’s game. To be successful you have to predict the future. You would have to know what companies will do well next year, and the year after that, and the next, and so on, and you would have to know it before everybody else knows it! Not only would you have to know how a company will fundamentally perform (i.e., its earnings and growth) but also how other investors will perceive and react to that performance and how expectations will change based on the overall economic environment, interest rates, and new tax and regulatory policies. There might be some great financial advisors out there, but I have yet to meet one who can predict the future.

Investing is not about predicting the future—it’s about planning for the uncertain future ahead. It’s about balancing risks and rewards, planning for your personal cash flows to satisfy your income needs and expenses, meeting your retirement goals, adapting to changing circumstances and tax laws, and living a fulfilling and meaningful life. No client has ever told me their goal in life is to “beat” the S&P 500, nor should it be. You should never obsess over some arbitrary benchmark, especially during periods of extreme market concentration like the present. Such periods are good reminders of why we diversify and why we focus on things we can control, like strategic tax planning, minimizing fees and expenses, diversification, asset location, rebalancing to manage long-term risk, and cash flow modeling to understand appropriate savings and withdrawal strategies.

Also, diversification works! It doesn’t always feel like it works because it often provides the greatest benefit in a down market—and investors tend to be unhappy with any loss, even when the loss is less than a benchmark. The greatest benefit of a diversified portfolio is not super-charging returns during up markets, rather it is minimizing losses during periods of declining markets or highly volatile periods. Over time and through multiple market cycles this can lead to overall outperformance. The below table illustrates this over the last 20-plus years of returns for a diversified strategy compared to the S&P 500. As you will see, during most of the intervening time periods investors generally felt unhappy with their returns, but over the full period the diversified strategy actually did slightly better—and with less risk!

The real risks of benchmark envy occur when investors compare their performance to the top companies in a highly concentrated market and feel inadequate or dissatisfied with their more diversified portfolio’s returns. This psychological phenomenon can have adverse effects and lead to imprudent and unnecessary risk taking. In an attempt to match or surpass the returns of market leaders, investors may take on excessive risks, investing in highly volatile assets or engaging in speculative trading that are beyond their risk tolerance. Wealth accumulation and financial success are highly personal and unique to each individual or family. Benchmark envy can lead to a misalignment of these goals, causing investors to chase returns that do not align with their long-term financial planning, and only leads to higher levels of stress and anxiety, both bad emotions when making financial decisions.

Concluding Thoughts

In times like these, the best advice is to avoid benchmark envy and focus on your personal financial planning and long-term goals. The S&P 500 has become a heavily concentrated, tech-focused index and is a poor benchmark to measure your own success. It is tempting when you see its returns, but those returns are just from a few stocks with lofty valuations and highly uncertain futures. Don’t be tempted to take unnecessary risks. During these periods of concentrated markets, the value of diversification is at its highest—the payoff just doesn’t come until the future. Remember, you don’t have to predict the future to be successful, rather, focus on planning for the uncertain future ahead, with a balanced and comprehensive approach. Trust in the benefits of a long-term diversified strategy, which has been proven through numerous past market cycles. Don’t focus on maximizing your rate of return against some arbitrary benchmark—focus on maximizing your personal happiness and life’s fulfillment.

The S&P 500 can’t benchmark your happiness, and true wealth isn’t a number or a rate of return—it’s a feeling.

Sources:

1. “View From The Top: 1999 vs. Now.” Bespoke Interactive, 18 June 2024, www.bespokepremium.com/interactive/posts/think-big-blog/view-from-the-top-1999-vs-now. https://www.bespokepremium.com/interactive/posts/think-big-blog/view-from-the-top-1999-vs-now
2. “Financial Advisor Resources for Client Conversations.” BlackRock, www.blackrock.com/us/financial-professionals/practice/conversation-starters. Accessed 17 July 2024. https://www.blackrock.com/us/financial-professionals/practice/conversation-starters
3. “S&P 500®.” S&P Dow Jones Indices, www.spglobal.com/spdji/en/indices/equity/sp-500/#data. Accessed 17 July 2024. https://www.spglobal.com/spdji/en/indices/equity/sp-500/#data
4. “S&P 500 Equal Weight Index.” S&P Dow Jones Indices, www.spglobal.com/spdji/en/indices/equity/sp-500-equal-weight-index/#data. Accessed 17 July 2024. https://www.spglobal.com/spdji/en/indices/equity/sp-500-equal-weight-index/#data
5. “Spy: SPDR® S&P 500® ETF Trust.” State Street Global Advisors, www.ssga.com/us/en/intermediary/etfs/funds/spdr-sp-500-etf-trust-spy. Accessed 17 July 2024. https://www.ssga.com/us/en/intermediary/etfs/funds/spdr-sp-500-etf-trust-spy