ConcentrationSeptember 16, 2020 -
Categorized in: Uncategorized
Concentration was not my strength as a grade school student.
One day in second grade I packed up my bag and started walking home when the bell rang for first recess. I had just spent the previous who knows how long daydreaming instead of listening to Mrs. Sebald.
Thankfully, she caught me before I got too far, but more concentration would have saved me from some embarrassment.
Too much concentration can also create challenges. The S&P 500 index is a great example of this so far this year.
The S&P 500 is a cap-weighted index. This means that companies with the highest value of total stock outstanding receive the highest weighting when calculating the index.
The challenge is that the S&P 500 index is becoming more and more concentrated in a small number of huge technology companies. These five technology companies now make up almost 25% of the S&P 500 index by value which means the index is becoming less and less diversified by sector and by individual companies.
The year-to-date performance difference between these huge technology companies and all of the other companies included in the S&P 500 index is stunning:
Hindsight is very clear that so far this year traders would have been better off owning a very concentrated portfolio of only five technology stocks while ignoring every other company in the world.
Unfortunately, hindsight investing is not an implementable investment strategy. This means concentration can also be a huge disadvantage.
The last time the S&P 500 had such a high concentration in technology companies was in late 1999 and early 2000. The following 12 months quickly erased any short-term benefit of traders’ previous technology concentration.
We do not know when traders will tire of the big 5 and turn their attention to less-loved companies. However, our underlying long-term philosophy is that portfolio concentration in a few companies poses more investment risk than a diversified portfolio that is rebalanced using a disciplined process.
While concentration creates the potential for outsized short-term returns (both positive and negative), diversification creates the potential to create a smoother path toward your long-term goals.
Looking back, I would like to think that perhaps my lack of concentration in second grade was really a failed attempt to diversify both student outcomes and physical locations. But we both know that is only true in hindsight.
Quote of the week: Milton Friedman: “Concentrated power is not rendered harmless by the good intentions of those who create it.”
Securities offered through LPL Financial. Member FINRA/SIPC. Investment advice offered through IAG Wealth Partners, LLC, (IAG) a registered investment advisor and separate entity from LPL Financial.
The S&P 500 is an unmanaged index of 500 U.S. large cap stocks. One cannot invest directly in an index.
Past performance is no guarantee of future performance. In fact, the opposite can be true. The information contained in this report does not purport to be a complete description of the securities, markets, or development referred to in this material. Investing involves risk including loss of principal.
Any opinions are those of IAG and not necessarily those of LPL Financial. Expressions of opinion are as of this date and are subject to change without notice. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. No strategy assures success or protects against loss. Investing involves risk including loss of principal.