As a physicist, I've always been fascinated by the intricate patterns and systems found in the natural world. From the elegant equations that govern celestial motion to the intricate interactions of particles within an atom; there’s a fascinating balance that keeps our universe in harmony.

The concentration in the US Equity Market

But, when I shift my attention to the complexities of the financial world, I encounter a different kind of pattern - one that raises concerns and challenges the principles of diversification. Specifically, I’m referring to the alarming concentration within the US equity market.

To grasp the scale of the US market's dominance, consider that according to MSCI data as of May 2023, the US equity market accounts for approximately 60% of the MSCI All Country World Index and around 70% of the MSCI World Index. These statistics alone demonstrate the significant influence the US holds on the global financial landscape, much like a celestial body overshadowing its counterparts and casting a wide-reaching shadow.

Mega-Cap companies and their astronomical influence

The story of concentration doesn't end there. The S&P 500 is heavily influenced by mega-cap companies that have grown to astronomical sizes. Take a moment to absorb this notable contrast: tech giants like Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla have experienced an impressive average year-to-date return of 84%, while the rest of the S&P 500 lags behind at an average of approximately 4%. This divergence is striking, reminiscent of the collision of particles with vastly different energies.

These seven largest companies form an elite league and now command a record-breaking 25% share of the total market capitalisation. Their dominance resembles the concentration of matter within a neutron star, compressing immense wealth and influence into a compact space. Just as the concentration of mass in a neutron star creates instability and the potential for collapse, the concentration of power in the US equity market leaves it vulnerable to shocks.

To truly understand the magnitude of their dominance, let's zoom in on Apple - an embodiment of innovation and success. Apple's market capitalisation alone (now c.$3 trillion) equals the entire Russell 2000 Small Cap Index. The gravitational pull of this tech titan, with its weight in the market comparable to that of an entire universe of smaller companies, is remarkable.  

Recognising the risks: concentration threatening equilibrium

I've been trained to identify patterns and understand the delicate equilibrium that sustains a system. In the realm of finance, where concentration threatens this equilibrium, it becomes crucial to acknowledge the associated risks. 

Passive market-cap weighted index funds have gained popularity due to their low costs and perceived ease of diversification. However, relying heavily on these investments can expose your equity allocation to the gravitational pull of a select few companies or sectors. This concentration risk can leave a portfolio vulnerable to market fluctuations and the performance of a limited number of stocks.

To navigate these potentially turbulent waters successfully, embracing the principles of diversification is imperative. Just as the laws of physics dictate that a stable system requires a balance of forces, a well-rounded portfolio demands exposure to investments across various styles, regions, and sectors. By doing so, you reduce the reliance on a single market or a handful of companies.

Uncovering Opportunities

By venturing beyond the confines of mega-cap companies, you open the doors to emerging opportunities, much like exploring uncharted territories. This approach not only mitigates concentration risks prevalent in the US market but can also uncover hidden gems that have the potential to fuel long-term growth. For example, investing in smaller-cap companies, emerging markets, or other niche styles and sectors can provide diversification benefits and access to new sources of returns.

However, it's important to note that diversification alone can't eliminate all risks. Thorough research, understanding the fundamentals of investments, and assessing their potential risks and rewards are crucial for constructing a well-rounded and resilient portfolio. Just as physicists delve into the complexities of the natural world, investors must navigate the intricacies of the financial world with care and knowledge.

If you would like to discuss further, then please get in touch.

This blog is based upon our understanding of events as at 5 July 2023. It a general summary of topical matters and should not be regarded as financial advice. It should not be considered a substitute for professional advice on specific circumstances and objectives. Where this blog refers to legal matters please note that Hymans Robertson LLP is not qualified to provide legal opinion and therefore you may wish to obtain independent legal advice to consider any relevant law and/or regulation.

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