INVESTORS are almost always admonished to be diversified. Conventional wisdom says that spreading your funds across geographies, industries and companies makes for a more resilient portfolio. Returns may not shoot the lights, but drawdowns are also unlikely to be deeper than the market.
But diversification may now be more elusive for two reasons. One is that in a globalised world, correlations among assets can rise rapidly, especially when crises accelerate as they have in the recent past.
The second reason – arguably an immediate issue – is that markets themselves are more concentrated now than ever before. Hence, finding assets that can serve as true diversifiers for portfolios, especially for mass affluent and retail investors, may well be challenging.
Concern over concentration risk is rising, thanks to the outsized share of the US stock market – and US technology stocks in particular – in global indices.
To be sure, market concentration itself is not unusual. The 2024 edition of the UBS Global Investment Returns Yearbook, which captures more than 100 years of market data, finds that of 12 markets, including some in Asia, the US is the second least concentrated after Japan. In Switzerland, for instance, the 10 largest stocks account for 72 per cent of the market, compared to 25 to 30 per cent in the US.
But the calculus may now be different due to the robust rise of the so-called Magnificent Seven stocks, buoyed by optimism over the potentially transformative power of artificial intelligence.
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The stocks – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla – account for more than 30 per cent of the S&P 500 and powered well over half of US stock returns in 2023. Even the MSCI World Index itself has become concentrated. The US’ share of the MSCI World Index exceeded 70 per cent as at end-February, and the seven stocks accounted for a fifth of exposure.
Should investors worry? The trajectory of the big-tech stocks commonly evokes the bursting of the dot-com bubble in 2000. At its trough in 2002, the Nasdaq lost 80 per cent. But there are marked differences between bubble-era stocks with zero earnings and the mega-caps today.
Today’s megacaps boast “tremendous earnings capacity”, as highlighted by JPMorgan Asset Management in a report. Profit margins for the 10 largest US stocks stood at close to 20 per cent as at end-2023, compared to around 12 per cent for the broader market.
At least four stocks pay dividends to boot. Meta, for instance, recently announced its first-ever quarterly dividend, in addition to an expanded share buyback programme, which bodes well for returns on equity. Apple, Microsoft and Nvidia also pay dividends.
The rub is that valuations can easily become unmoored, more so as earnings expectations rise. The Magnificent Seven are trading at a forward price-earnings (PE) multiple of 30 times currently, compared to the broader market’s PE of less than 20 times.
Investors cannot ignore the US market’s growth and returns, and hence, diversification remains a must. Fixed income assets have a place in portfolios to help offset equity volatility. Those who can get access and are able to tolerate illiquidity may also cast their net wider into alternative investments, including private market assets.
However imperfect, diversification enables investors to stay the course despite volatility. This is key to reaping long-term returns.
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