This year’s outsized performance by the S&P 500, a popular large-company index, is currently being driven by just a handful of companies commonly referred to as the Magnificent Seven, which includes Apple, Amazon, Meta Platforms (Facebook), Alphabet (Google), Microsoft, Tesla, and Nvidia. These large companies have attracted lots of investor interest and while growing at impressive rates, they trade at lofty valuations as measured by P/E (price to earnings) ratios with little margin for error if they fail to meet Wall Street expectations. The S&P 500 is priced at about 18 times projected earnings, but these seven companies are trading at an average P/E of almost double that. In 2022, the Magnificent Seven accounted for 17% of the S&P 500’s earnings but currently account for 30% of its valuation.
Given the supercharged performance of the S&P 500 this year, what’s the big deal about being more broadly diversified? The purpose of broad diversification, which cannot be overstated, is to reduce the risk associated with being heavily concentrated in companies, economic sectors, or styles while enabling an investor to participate in the increasing values of a larger number of companies over time. Broad diversification also means you will always under-perform whichever style, sector or group of companies happen to be most favored at any point in time. A broadly diversified portfolio will include the Magnificent Seven, but in moderation to make room for other companies. An interesting definition of diversification is that you never own enough of anything to make a killing, or to be killed by it.
History is filled with examples of companies or economic sectors that benefited from sky-high momentum until they didn’t. By the time the pendulum swings it will be too late to react and most investors will ride their over-concentrated positions right back down with little to show for it. Ok, then why not put all of your money in the S&P 500 and forget it? That is certainly an option, and not the worst one. However, the S&P 500 is a cap-weighted index in which the largest companies comprise the bulk of its value. Those companies’ influence on the performance will be overly rewarding when rising and painfully punitive when falling. By more broadly diversifying an investor allocates resources into a less concentrated portfolio and is willing to forego chasing the “hot dot” for a less volatile, less risky, and hopefully, more enduring wealth creation outcome.
Samuel J. Taylor, CIMA®, AIF®, CRPC®
Wealthview Capital, LLC