“The border between brilliance and stupidity is hard to discern.” – William Green, author of Richer, Wiser, Happier

Many investors are placing a massive bet on a concentrated momentum index.

The problem is most do not know it.

It’s okay to take known risks. We understand the potential worst- & best-case outcomes.

It’s perilous to take unknown risks. Even worse, taking unknown risks and thinking you’re protected.

We call it fake diversification.

When someone invests $100 in their 401k and buys the S&P 500, they think they’re getting a diversified basket of 500 of the largest companies in the United States. This is technically true.

What’s really happening is $40 goes to a handful of companies. What they’re buying is a concentrated basket of the most expensive, largest, and best performing stocks in the index.

Source: Charlie Bilello

The above graph shows the S&P 500’s weighting of top 10 holdings going back to 1980. The popular index is more top heavy than any point during the past 45 years.

Here’s another look at how index concentration has evolved…

Source: Mike Zaccardi

The above graph shows the biggest companies by decade going back to 1985. Today’s setup is the most concentrated the S&P 500 has been in history. Notice how corporate leadership changes over time; it would seem yesterday’s winners often have trouble staying on top of the corporate hierarchy.

More concerning, many of these investors own the S&P 500 and directly own the individual stocks that make up the index concentration.

That’s the equivalent of going through a fast-food drive through and ordering…

Bacon cheeseburger

Cheeseburger w/bacon

Bacon, add cheese and meat.

Investors are doing the same thing when they own the S&P 500, Nasdaq (tech index), and individual technology stocks.

Meb Faber, founder of Cambria funds, points out the top 8 holdings of the S&P 500 are the same as the top 8 holdings of the Nasdaq Index.

The result is massive concentration, the illusion of diversification, and over-exposure to the best performing areas of the market (U.S. Large Cap & AI/Technology).

What could go wrong?

Michael Cembalest of J.P. Morgan points out, “AI-related stocks have driven 75% of S&P 500 returns since ChatGPT’s launch in November 2022. 80% of earnings growth over the same period and 90% of capital spending growth.”

In other words, much is riding on this AI trade paying off.

For investors with accounts spread over multiple advisors, personal trading accounts, and 401k plans, the unintended risks are even worse and often impossible to track. Here’s a prospective client portfolio we recently examined (this is becoming way too common)…

Source: Koyfin

The above matrix shows a sample household portfolio consisting of Vanguard Total Stock Market Index (VTI), Vanguard S&P 500 Index (VOO), Nasdaq (QQQ), and Vanguard 500 Index (VFAIX). The prospect also held direct exposure to Nvidia (NVDA), Oracle (ORCL), and META.  The prospect held several “diversified” funds, however, 40% of their retirement assets were concentrated to handful of stocks leveraged to the AI trade. The overallocation is virtually impossible to spot by the novice eye, especially when the index holdings are held across multiple accounts.

Why is this a big deal?

Many investors are taking a massive leveraged bet in a handful of high-flying companies and don’t know it. Again, it’s fine to take known risks. It’s potentially catastrophic to take unknown risks.

You want to know what you own, why you own it, and the role it plays in your portfolio. If you can’t answer those questions, you’re probably invested incorrectly.

Why would an investor change their allocation if U.S. Large Cap & Technology have achieved massive returns?

Markets move in cycles, while timing is fleeting, the best performing asset classes often rotate through time.

Source: Ritholtz Wealth Management

The above chart shows the best performing asset classes between 2000-2009. The “lost decade” for the S&P 500 was preceded by the massive .com crash of 1999-2000. Many investors that crowded into the euphoric technology trade were crushed. Back in 2009, no one was asking if they should put a large chunk of their retirement savings into the S&P 500.

Here’s how the humble investor could proactively tighten up their portfolio today…

• Make sure you know what you own. This is especially important if you own a bunch of mutual funds, ETFs, and individual stocks across multiple accounts (see the above holdings matrix).
• Don’t go overboard or chase the best performing themes. Own AI, but don’t chase or get outside your risk tolerance. Be mindful of position sizing.
• Diversify – In our opinion, virtually every other equity asset class has a better risk/return profile vs. U.S. Large Cap. Think emerging markets, international developed, small cap, the value factor, public real estate (REITs). The investment universe extends beyond the S&P 500.
• Don’t wing it – making decisions based on your gut or listening to predictions is a sure-fire way to get it wrong.

Many investors think yesterday’s gains will continue uninterrupted. If history rhymes, higher returns today could equal lower returns tomorrow. It’s easy to forget about risk management when markets are trending higher.

We are not calling for the end of the AI trade or a market crash. We encourage leading with risk management, prudent position sizing, humility, and building a long-term investment plan you can stick to during all market environments.

Want to dissect your portfolio and know exactly what you own? We can run your holdings through our matrix and understand your risk exposure before the next market event happens. Shoot us a note at insight@pureportfolios.com.