Concentration risk can be a double-edged sword, offering the potential for significant gains but also exposing investors to devastating losses. Recent market trends have amplified this risk, making it crucial for investors to understand and manage their portfolio concentration effectively.
The Current Market Landscape
We began discussing the unprecedented levels of concentration in the U.S. market a couple of OUTLOOKs ago when it surpassed the extreme weightings seen in the late 1990s and 1970s. Fast forward, and this concentration has increased beyond anything we have ever seen before.
When combining the weightings of the Technology sector with technology companies in the Consumer Discretionary (Amazon, Tesla, etc.) and Communication Services sectors (Meta Platforms, etc.), they comprise almost 40% of the S&P 500 Index. This concentration makes direct comparisons between portfolios and historical benchmarks increasingly difficult.
Understanding Portfolio Performance
Two critical factors determine portfolio performance:
1. How well individual investments perform
2. How much of each investment you own
Now, if you invested in a company that doubled in value over the past year, did you invest 4% of your consolidated portfolio or 40%? If you invested 4% in the greatest AI company of all time, you still underperformed the S&P 500 Index. However, are you comfortable investing $2 million of your $5 million portfolio (i.e., 40%) in one area?
The Pitfalls of Benchmark Comparisons
It has been said that comparison is the thief of joy. When it comes to the fear of missing out on portfolio winners, this can certainly be true. But are you comparing apples to apples?
When using general indices as benchmarks, it's essential to examine their components carefully by:
• Asset classes (equities, fixed income, alternatives, etc.)
• Geographical distribution (U.S., European, Latin American, Asian, etc.)
• Sector concentration (Healthcare, Consumer Staples, Energy, Materials, etc.)
• Market capitalization (large, mid, and small)
• Investment style (value or growth)
Based on market capitalization, North American companies comprise just over half of the world’s developed equity market but less than half the global economy. Limiting investments to a single region or sector may increase unnecessary risk and miss potential opportunities.
A Goal-Oriented Approach
Instead of fixating on index performance, consider adopting a more holistic, big-picture approach focused on personal and financial goals. Here are some key questions to guide your planning:
• What specific lifestyle do you want to maintain in retirement, and how much monthly income will you need to support it?
• How much do you need to save annually to fund your child's or grandchild’s tertiary education in 15 years, considering projected tuition increases?
• What are your long-term philanthropic goals, and how do you envision your family's involvement in achieving them?
Additionally, consider key factors such as cash flow needs, time horizon, risk tolerance, and liquidity constraints. This approach is more prudent than solely comparing your performance to what an individual index did last quarter.
BOTTOM LINE
Diversification remains a fundamental principle of sound investing, but it requires more than simply spreading investments across different assets. It demands a thorough understanding of your portfolio's composition, correlation between assets and macro geopolitical themes, and alignment with your personal financial goals.
At SANDSTONE, we regularly work with clients to ensure our tailored investment strategy suits their unique financial and personal situation. If you have any questions or would like to give us a call, our door is always open.