Experts warn of the risks associated with extreme market concentration

With over a quarter of the S&P 500 dominated by just five companies – Nvidia, Microsoft, Apple, Meta, and Amazon – experts warn of the risks associated with extreme market concentration.

Key points:

• High concentration in the S&P 500 can be risky for investors. If one brand stumbles, the whole market will be impacted. 

• Small and mid-sized stocks perform well in periods of extreme concentration, especially when the market rebalances itself. 

• Tips for diversifying your investment portfolio:

  • Go global with investments

  • Equal-weight indices give smaller companies a chance to shine 

  • Fundamentally weighted indices help reduce the risk of being caught in ‘market bubbles’

  • The capped index means you can still tap into the success of market leaders, while avoiding overreliance on just a few names. 

Damien Jordan, founder of Damien Talks Money and FinancialInterest.com, has given his perspective on the current market and what you can do to reduce concentration risk. 

Damien addresses the current state of the market: “We’re at a very interesting point in time when it comes to the S&P 500. As it stands, it’s highly concentrated by big household names, which are typically investment favourites. But if one of these brands were to stumble, the whole market could feel the impact. If we’ve learnt anything from history, it’s that concentration of this kind can be risky for index investors.

“Wall Street’s top analysts have become increasingly wary about the dominance of a few enormous companies in the S&P 500. Goldman Sachs has pointed out that market concentration is at levels not seen in decades, warning this could severely limit returns over the next ten years. 

“Morgan Stanley echoed similar concerns, highlighting that when just a handful of companies lead the market, it effectively reduces diversification, making portfolios vulnerable if any of these giants stumble. JPMorgan researchers noted that in past periods of extreme concentration, small and mid-sized stocks tend to outperform significantly once the market rebalances itself.

“Despite these concerns, history suggests that dominance is nothing new. When looking at the largest three companies by market capitalisation at the end of each year from 1950 – 2023, only 17 stocks are on the list1.

How can you diversify your portfolio outside of the modern behemoths?: 

“If staking your future on the fortunes of Silicon Valley makes you feel uneasy, or you want to build a portfolio that you expect to access sooner, there are some ways for people to diversify their portfolio – without switching away from the S&P 500 entirely, if that’s what they’re looking for.

1 – “Go global. If you don’t want to have all your eggs in the US basket, a global fund might be a more suitable approach. Global indices are still dominated by the US, making up around 66% of the total market at this time, giving large-but-not-exclusive exposure to the S&P 500.

2 – “You could look at equal-weight indices. With an equal weight index, every company gets the same slice of the pie, whether it’s Apple or a firm you’ve never heard of. This reduces reliance on the biggest names and gives smaller companies a chance to shine. Over the very long term, equal-weight indices have even outperformed their market-weighted counterparts (though past performance isn’t a reliable indicator of future results). 

3 – “Or, you could consider fundamentally weighted indices. Known as ‘smart beta’, it means choosing companies based on real-world fundamentals like revenues, earnings, dividends, or assets. It’s an approach that prioritises substance over style. By focusing on economic strength, these strategies avoid overhyped stocks with no earnings that rely solely on potential. Historically, they’ve tilted towards undervalued companies, so-called “value stocks”, which can help reduce the risk of getting caught in market bubbles. 

4 – Finally, there’s the capped index. Meaning there’s a limit on how much influence any one stock or sector can have. If one company starts to dominate, it gets trimmed back when the index is rebalanced. This is about keeping the market from being completely taken over. A capped index means you can still tap into the success of market leaders, while avoiding overreliance on just a few names. 

These approaches all have their pros and cons, and fees will likely be higher if you’re looking into more niche fund options. But the main thing to note is that there isn’t just one option that everyone has to stick with — there are choices out there, you just need to know what you’re looking for.”

Damien finishes by saying: “The S&P 500 is a global favourite, but right now it’s unusually dominated by a small number of tech giants. That’s not necessarily bad, these companies have genuinely earned their spot. But it does mean extra risk for those intentionally trying to seek diversification.”