How concentration risk in the S&P 500 could hurt your portfolio

• The top 10 companies in the S&P 500 have accounted for as much as 35% of the index’s market cap in recent months.¹
• For investors, this concentration could leave their portfolio vulnerable to potential losses if interest rates remain high and stock values decline.
• Investors should consider small-caps, cyclicals, and emerging markets to actively diversify.

Investors have aggressively flocked to the biggest US consumer-tech stocks for their perceived defensiveness or ability to weather tough economic times, helping drive their lofty valuations even higher. In fact, the most highly valued public company in the US has a valuation greater than the entire UK stock market, and twice the size of Germany.

These stocks dominate the benchmark S&P 500 Index.

Why does this matter? Rather than providing a true defense, the concentration could leave investors’ portfolios less diversified than they might think. Consider the following:

• First, investors in the S&P 500 Index may think they are getting exposure to a diversified basket of 500 companies. But the top 10 mega-cap companies in the index have accounted for as much as 35% of its entire market capitalization in recent months compared with an average of 20% over the past 35 years. This means that money deployed into the S&P 500 is increasingly a wager on the health of just a few companies—with the fundamentals of the other 490 carrying less weight.
• Second, expensive stocks keep getting more expensive. This is a risk because rich price-to-earnings (P/E) valuations are extremely dependent on low interest rates, which tend to make the projected value of these companies’ future earnings look more attractive to investors. Should the Federal Reserve keep policy rates higher for longer, the index may be more rate-sensitive and subject to greater volatility than many investors assume.

Source: Morgan Stanley Wealth Management Global Investment Committee as of May 22, 2023.

• Finally, the risk of over-concentration in investors’ portfolios is further exacerbated by the US stock market’s growing weight in global equity markets. US stocks make up as much as 60% of the value of all stocks in the world. With global monetary policies and economic growth rates set to diverge—and with most non-US markets priced at a more reasonable P/E ratio, looking outside the US could be a better move toward a balanced portfolio.

With expected returns for the market-cap-weighted S&P 500 projected only a couple of points above “low-risk” US Treasuries, diversification may be more important than ever and may require an active approach to portfolio management.

Long-term investors should consider moving away from US passive index exposures like the S&P 500 toward opportunities in:

• small-cap,
• value-style,
• and cyclical stocks.

Meanwhile, tactical rebalancing could also favor emerging markets over the next six to 12 months.

The source of this article, “Why Investing in the S&P 500 Isn’t True Diversification” was originally published on May 24, 2023.

1. Source: Morgan Stanley Wealth Management, Bloomberg, as of May 17, 2023.