Hidden Concentration in Your Investment Portfolio
Brian McGeough
Diversification is a key factor when constructing an investment portfolio that will help meet your long-term financial goals. This goes beyond just allocating between stocks, bonds and alternative investments. Diversifying within assets classes by investing in a variety of securities, industries and geographical regions is also important.
But a mistake that is often made is that investors have a high concentration of certain sectors or stocks without even realizing it. The technology sector makes up approximately 27% of the S&P 500 index. Furthermore, five stocks make up 20% of the S&P 500! The NASDAQ consists of 54% technology stocks and the Dow Jones Industrial Average is made up of 17% technology stocks. The charts below show the sector allocation and stock weightings of the S&P 500.
Source: CNBC.com
Source: CNBC.com
Often times investors think they are diversifying their portfolio by investing in a mutual fund or ETF that corresponds to the performance of the S&P 500. As illustrated above, you can see that not only would your investment be heavily skewed toward the technology sector, but would also have a heavy weighting in just five stocks.
And, looking at five very popular mutual funds within the same company, there are quite a few of the same technology stocks that are in the top 10 holdings in each of those funds. To compound matters, people will also add popular individual stocks to their portfolios such as Apple, Microsoft and Google, adding even more concentration to their portfolio. So even picking different mutual funds can result in an over concentration of the technology sector and stocks.
While owning large cap technology stocks is certainly not a bad thing, and, over the long-term can provide superior returns, it is important to be in the right sectors at the right time. Higher interest rates have a more negative impact on growth stocks (i.e. tech stocks) than other sectors. When the Federal Reserve started raising interest rates in 2022 to fight high inflation the result was that the NASDAQ was down 33%, the S&P 500 was down 20% and the Dow Jones was down 8%, which would make sense given the allocation of technology stocks in each index.
Understanding how different economic scenarios affect different investment sectors is very important. Investors should know where we are in the economic cycle, what their sector and stock allocations are and make sure that they align with their investment time horizon and risk tolerance.