Market indexes designed to represent total stock markets or broad subsets of a market are generally thought to offer investors high levels of diversification. Well-known indexes, like the S&P 500® Index and Russell 3000® Index, hold hundreds or thousands of companies. Yet, by some measures, many major indexes appear more concentrated today than ever.
Does that concentration expose investors to unnecessary risk as market returns can be significantly impacted by just a few, large holdings?
Index Concentration is Greatest Today Among U.S. Large Caps
The above chart shows the weight of the top 10 largest companies in three major indexes.
- S&P 500: By the end of 2024, the top 10 companies in the S&P 500 represented a staggering 37.3% of the Index's total market capitalization. In other words, just 2% of the 500 largest U.S. companies represent nearly 40% of the weight of the entire index.
- Russell 1000 Growth: This is even more extreme in growth stocks: the average weight of the 10 largest companies in the Russell growth index is 6.1% each, while all other companies average just 0.1%.
- Russell 1000 Value: The chart clearly shows that only the Russell 1000 value index has a concentration percentage in line with (or lower than) historical precedent.
Heavy Weights: The Real Story Behind Current Market Concentration
Understanding the drivers behind this increased concentration is crucial for investors. A handful of big companies, often called the Magnificent 7 (Mag 7: Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA) stocks, had unexpectedly high price increases and became an even larger fraction of the total U.S. market capitalization. The high returns concentrated among these select companies played a large role in lifting the entire S&P 500.
The below chart illustrates the growth of $1 from 2022-2024 in the Mag 7, the S&P 500, and International Developed Markets (Source: Bloomberg).
What’s Behind the Increase?
Clearly, the largest companies have outperformed overall markets, resulting in concentration levels that are at historical highs. This begs the question: what exactly has caused such performance?
Historically, economic and business growth result in increased corporate earnings and subsequently higher stock prices. While earnings have been strong for many of the largest companies, stock prices have, on average, gone up far more. This means that the expansion of valuation multiples like price-to-earnings (P/E) has played a big role. In other words, investors are now paying more for the same earnings than in years past.
That’s Interesting to Know, But What do I do About It?
It's important to remember that high concentration alone doesn't necessarily predict future returns. However, elevated valuations of the largest companies warrant careful consideration. What should investors do about it within their portfolios?
- Pay attention to valuations
- Diversify
Consider that there’s far more opportunity for investors than just the 7 largest companies, or even the entire S&P 500, and increased valuations at the top of the U.S. market haven’t been matched in other areas globally. Today’s U.S. small cap and international stock valuations look to be in line with long-term averages, potentially making them more attractive investments.
This doesn’t mean that the largest U.S. companies should be avoided entirely. Far from it, in fact, as they’re still a big part of the market and, given their current size, not holding them would result in a very different return experience through time than the overall market.
The key lies in finding a balanced approach. With a diversified portfolio, you know you won’t have the highest return over any period, but you also have some protection from having the lowest return. If those very big, high-priced companies fail to continue delivering unexpectedly strong performance going forward, being diversified across company sizes, nations and valuation profiles may make a big difference.
Disclosures:
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The S&P 500 is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States. The Russell 3000 Index is a capitalization-weighted stock market index that seeks to be a benchmark of the entire U.S. stock market. The Russell 1000 Index consists of the 1,000 largest companies by market capitalization in the Russell 3000 Index, which represents approximately 90% of the total market capitalization of the Russell 3000 Index. It is a large-cap, market-oriented index and is highly correlated with the S&P 500 Index. Indexes are unmanaged and cannot be invested in directly.
The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. Indexes are unmanaged and cannot be invested in directly. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
The prices of small cap stocks are generally more volatile than large cap stocks.
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