Market Volatility Exposes Hidden Risks
The recent stock market downturn sent a stark warning to investors: beware of concentration risk. While artificial intelligence giant Nvidia Corp. took the biggest hit, the ripple effects were far-reaching due to the top-heavy nature of broad market indexes.
The Illusion of Diversification
Many investors assume that indexed ETFs, which track a basket of 500 stocks, provide adequate diversification. However, the reality is that these indexes are often dominated by a handful of high-flying stocks. According to Craig Toberman, partner at Toberman Becker Wealth, “For anyone invested in the S&P 500 Index, Nvidia is probably their biggest holding.” This concentration of wealth in a few stocks can have devastating consequences for investors who are not prepared.
The Weight of Concentration
The combined weighting of the smallest 490 stocks in the S&P 500 has not been this light since the dot-com bubble of the late 1990s. This is a grim reminder that betting big on indexes weighted by market capitalization can be a recipe for disaster. Toberman recommends diversifying portfolios by allocating to a good world stock market index, rather than relying solely on the S&P 500.
Beyond Market-Cap Weighted Indexes
Ryan Graves, president of Bemiston Asset Management, points out that while the S&P 500 fell by 1.5% on Monday, 350 of the underlying stocks finished the day in positive territory. This highlights the need for investors to look beyond market-cap weighted indexes to find true diversification. Stephen Kolano, chief investment officer at Integrated Partners, agrees that the recent market selloff should serve as a wake-up call to investors and financial advisors about the risks of concentration.
Alternative Paths to Diversification
So, what’s the solution? One option is the Invesco S&P 500 Equal Weight ETF (RSP), which provides broad market exposure without being dominated by a few high-flying stocks. While this approach may not offer the same level of returns as a concentrated portfolio, it can provide a smoother ride for investors. As Kolano notes, “Given the level of concentration AI has taken up in the markets, there is a broader market impact.” By diversifying their portfolios, investors can reduce their exposure to concentration risk and sleep better at night.
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