The core principle of investment diversification—spreading assets to reduce risk—is facing new scrutiny as market concentration, particularly in technology and AI, reshapes global indices. While diversifying has long been considered the best way to mitigate losses and reduce portfolio volatility, experts suggest that traditional approaches may not offer the protection they once did. The aim of diversification is to ensure that no single investment is large enough to cause significant damage to overall returns. A balanced approach, incorporating various asset classes like stocks, bonds, property, and commodities, alongside geographic and market-type spread, is generally recommended. However, the current market landscape presents a challenge to this strategy.
Concentration Risk in Global Markets
A key concern is the increasing dominance of a few large companies, especially within the technology sector. A standard global tracker fund, which passively follows market performance, often leads to an over-exposure to U.S. markets, where tech giants play a significant role. For instance, the so-called "Magnificent Seven"—Nvidia, Microsoft, Apple, Alphabet, Amazon, Meta, and Tesla—now constitute a substantial portion of indices like the S&P 500. When AI-related infrastructure companies are included, the top ten stocks can represent over a third of the entire index. This concentration is not limited to the U.S.; emerging market indices are also being reshaped by the AI investment boom, with a significant portion now tied to semiconductor manufacturers in regions like Taiwan and South Korea.
James Scott-Hopkins, founder of wealth manager EXE Capital Management, notes that while diversification is crucial for reducing volatility, "overdoing it will likely mean poorer returns." He highlights the current concentration risk, stating, "nearly half the S&P 500 in AI-related businesses." Darius McDermott, managing director at FundCalibre, likens this to a scenario where "if every basket sits on the same cart, it doesn't matter how many you have; one pothole and they all bounce the same way."
Rethinking Diversification Strategies
To counter this concentration risk, investors are advised to consider alternative strategies. One approach is to utilize equal-weighted funds, which allocate equal weight to each company in an index, rather than weighting them by market value. This method reduces dependence on a few dominant stocks and can provide broader market participation. For U.S. exposure, holding both a market-cap-weighted S&P 500 tracker and an equal-weighted version can offer a more balanced approach. Similarly, for global exposure, combining a traditional global tracker with an MSCI World Equal Weight ETF could be beneficial.
Another strategy involves investing in defensive global equity funds or global equity income funds that focus on resilient, dividend-paying stocks. These funds may offer a more stable alternative or complement to broad market trackers by avoiding exposure to highly concentrated sectors or companies. For example, some funds are specifically designed to have zero exposure to major tech players like Nvidia or Apple, acting as a more defensively minded diversifier.
Factor funds, described as "next generation" passive investments, offer another avenue. These funds hold a wide basket of shares but weight them based on fundamental characteristics such as sales, cash flow, book value, and dividends, rather than solely market capitalization. This approach aims to maintain broad diversification without relying on active fund manager judgment.
Foundational Diversification Principles
Despite these evolving challenges, fundamental diversification principles remain important. Experts recommend a balanced approach, suggesting a split such as 60-80% in equities and 20-40% in bonds and other assets to dampen market volatility. For individual stock pickers, holding 30 to 40 diversified holdings is advised, while a portfolio of 10 to 20 funds is generally considered sufficiently broad. Multi-asset funds are also presented as a convenient option, offering a pre-packaged diversified solution for investors seeking a hands-off approach. However, it is crucial for investors to assess their risk tolerance and investment goals when selecting any diversification strategy.