Rule 3: Index funds offer great diversification benefits.
Last year’s headlines, which continued through the New Year, threw light on a curious phenomenon in the stock market. It appears that a select few stocks, dubbed the “Magnificent Seven,” have been the primary drivers behind this past year’s market rally. These stocks – Apple, Microsoft, Amazon, Nvidia, Alphabet (both shares), Tesla, and Facebook – have indeed been performing spectacularly. Their combined returns far outpaced the rest of the index over 2022.
If we were to take the Magnificent Seven out of the equation, the rest of the stock market would not have performed so well. The significant difference in returns between a handful of top-performing stocks and the broader market raises a crucial point about concentration risk: it’s a phenomenon that’s not always in the spotlight, yet it’s playing out. It suggests real consequences for the perceived diversification offered by indexes—which might be somewhat misleading. When the performance and risk of the entire index are heavily influenced by just a few stocks, it encourages investors to look for active management to break up that concentration risk.
Typically, concentration risk is mitigated through actively managed strategies, like those employed by many investment firms including those we have partnered with. These strategies often involve a team of portfolio managers working across different asset classes and funds, aiming to stabilize returns and reduce the kind of risk that comes from over-reliance on a few stocks.
For instance, if we look at the composition of a typical actively managed portfolio versus an index like the Russell 1000, the difference in underlying concentration risk is evident. An actively managed portfolio might have a more diversified spread across its top 25 stocks compared to the index. This diversification means that the performance of the portfolio will naturally diverge from the index – sometimes performing better, sometimes worse, but crucially, not mirroring the index’s movements.
Active portfolio management strategies are designed to deliberately deviate from index benchmark returns, with the objective of managing risk more effectively. This approach acknowledges that while riding the wave with high-performing stocks can be rewarding, it’s also crucial to guard against the volatility and risk that come with over-concentration in a few market leaders. It’s a balancing act between capturing growth and safeguarding against potential market downturns, especially when the performance is heavily skewed by a small number of stocks.