The rising AI tide has lifted the biggest US tech companies to eye-popping valuations, fuelling anxiety about market concentration and fears that a stumble in a few mega-cap names could drag indices across the globe down with them. But is market concentration really the issue here?
Market cap-weighted indices have long offered investors simple, low-cost access to diversified equity exposure. That diversification is becoming increasingly distorted. As of this month, the top 10 stocks in the S&P 500 make up more than 40% of the index’s value, the highest on record, with Nvidia alone clocking in above 8%. Buying “the market” today isn’t as passive or diversified a decision as many think.
This is hardly a new debate but what does this mean and should you be worried about your investments?
Valuations always matter
High concentration on its own isn’t a reliable predictor of poor future returns. Historical data suggests it is valuation and not necessarily weight in the index that drives outcomes. And while today’s top tech stocks command high multiples, they’re also delivering staggering earnings and cash flows.
Contrast this with the dot-com bubble, a time when many companies had no earnings at all. Today, the “Magnificent Seven” have posted earnings growth three times greater than the rest of the S&P 500 since 2020. Apple, Microsoft, Amazon, and Google alone generated $1.8-trillion in revenue in the past year, more than the GDP of all but 15 countries. Their latest results show double-digit quarterly revenue growth. So perhaps the premium is warranted. The harder question is: how much is too much? As is usually the case, investors get ahead of themselves, and markets then overshoot to both the upside and the downside. Exuberance gives way to despondency, and vice versa.
What are the risks?
The risk isn’t that concentration exists, it’s what happens when expectations embedded in prices aren’t met. The S&P 500 and MSCI world indices are heavily tilted towards a few names, and if those few stocks correct, the whole index feels it. The second-order effect is that the rest of the stocks in those indices likely also move downward in sympathy with the apparent change in market momentum (as indicated by the index moves driven by mega-caps).
If diversification is what you’re after, perhaps an equal-weighted index should be considered instead of a typical market cap index. But that’s not necessarily a recipe for outperformance, just a more balanced exposure to risk. Avoiding the top-heavy names in the past few years has come at a great cost; those who’ve avoided them have seen their performance lag significantly.
It’s not just the US …
Investors worrying about concentration should look around as, surprising as it may sound, the US isn’t even the most top-heavy market. The JSE’s top 10 stocks make up near 50% of the all-share index. In Taiwan, TSMC alone accounts for 40% of overall market cap. Germany, Australia, South Korea and even the UK all have more concentrated markets than the US. Yet despite this, South African investors don’t seem as concerned about local concentration.
So yes, concentration exists but it’s not uniquely American, we just choose not to focus on concentration risk in our own or other markets. And given the strength of US earnings, it may not be irrational yet.
Don’t be lazy
Timing a turning point (or a “bubble” popping) is notoriously hard, and being early feels the same as being wrong. Yes, there may yet be a day of reckoning, but it’s not necessarily imminent and if the AI boom does deliver, today’s valuations may look cheap in hindsight.
While concentration does matter, it’s not the real danger: complacency is. The risk isn’t that you’re exposed, it’s that you might not realise how exposed you are (if a very broad, diverse passive portfolio is what you’re after).
Blind fear is lazy thinking, and this is exactly the environment where smart advice adds value. When narratives shift and markets move fast, the right guidance helps you act, not react.
Jordan Toy is a private wealth manager who specialises in constructing and managing portfolios.
Top image: Rawpixel/Currency collage.
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