There’s been plenty of publicity in recent months about the Magnificent Seven. No, I’m not talking about the classic Western starring Yul Brynner, Steve McQueen and Charles Bronson, but the seven big technology firms that have been dominating the US stock market: Alphabet (Google), Amazon, Apple, Meta Platforms (Facebook), Microsoft, NVIDIA and Tesla.
Some commentators have warned that the success of these stocks has made indices like the S&P 500 too heavily concentrated. But, historically, it’s not unusual for a small number of stocks to dominate an index. And, as new research by Vanguard demonstrates, investors who held the Magnificent Seven stocks in their portfolios have been amply rewarded. The researchers found that a simulation of the Russell 3000 Index without these seven companies would have lagged the back-tested Russell 3000 Index by approximately 2.1% per annum over the ten-year period to the end of 2023.
Interestingly, though, that same Vanguard study also found that it isn’t always so beneficial to own all of the biggest stocks. The researchers looked at returns over a 24-year period from the start of 2000. Although it appears to have been more important to hold the stocks that made the biggest positive contribution to index returns in recent years, it was actually more impactful not to hold the stocks that made the biggest negative contribution in the early years of the study.
Why was this the case? The reason, says Vanguard, is that up until 2014, small-cap stocks outperformed large-cap stocks. After 2014 that trend reversed.
“If large caps underperform small caps,” the study’s authors explain, “the gain from not holding the bottom performers tends to exceed the loss from not holding the top contributors. Conversely, if large caps outperform small caps, the loss from not holding the top contributors tends to exceed the gain from not holding the bottom contributors.
“Hence, the ‘direction of travel’ is, to a significant extent, determined by large-cap stocks.”
So what lessons, if any, can investors learn from this research? And how can they avoid being over-exposed to a small number of large stocks?
Lesson #1: Stay diversified
Clearly, if you had been clever (or lucky) enough to be heavily invested in small-cap stocks and then to predict, back in 2014, that the outperformance of small caps would go into reverse, you would have easily beaten the market over the course of Vanguard’s study period. Your returns would have been better still if you’d predicted the success of the Magnificent Seven.
But trends that look obvious in hindsight are very much harder to predict in real time. Very few investors, including the professionals, succeed in timing the market with any degree of consistency. Active fund managers, for instance, have far more expertise and resources at their disposal than ordinary investors, and yet, as the SPIVA scorecard from S&P Dow Jones and Morningstar’s Active/ Passive Barometer show us time and again, the vast majority of active managers fail to beat their benchmarks over time.
A far more logical strategy, then, than active investing — or trying to pick the right stocks or the right funds at the right time — is to invest in the whole market by holding a diversified portfolio of passive, or broadly passive, funds. That way, you are guaranteed to own all of the publicly listed stocks that make the biggest contribution to market returns in the future.
Yes, there is bound to be a time when large-cap stocks start underperforming small caps again. It’s inevitable too that technology stocks, which have performed so well in recent years, will eventually fall out of favour. It’s quite possible, in fact, that those two things will coincide, and, if they do, portfolios that are heavily concentrated in the Magnificent Seven will see their returns suffer.
But the beauty of highly diversified index investing is that you are never over-exposed to any particular slice of the market, and, at any one time, there are bound to be parts of your portfolio that have performed better than others. By avoiding the risks associated with stock selection and market timing, and by paying less in fees and charges, you give yourself an excellent chance of achieving your investment goals in the long run.
Lesson #2: Rebalance regularly
As we’ve seen, investment returns are cyclical in nature. Different types of securities inevitably fall in and out of favour. Consistently predicting when each inflection point will come is almost impossible. You might get it right occasionally, but, over time, you are bound to make bad calls too and those could cost you dearly.
An alternative and more rational strategy is simply to rebalance your investments regularly. Over time your portfolio will inevitably drift away from the asset allocation you originally decided on. Rebalancing simply restores your investments to that original allocation. It essentially means selling some of the assets that have performed well and reinvesting the profits you’ve made in assets that have performed less well.
In a sense, rebalancing goes against our better instincts. Investors are hard-wired to hold onto their best performers and avoid assets that have underperformed. That’s why it’s best to opt for automatic rebalancing, so that it happens without you having to think about it.
There are various ways of doing it. You can, for instance, rebalance at regular fixed intervals, or when the make-up of the portfolio deviates from the original allocation by a specific amount. But, whatever method or regularity you use, rebalancing will give you a smoother investment journey and make you better able to stay invested when part of your portfolio falls in value.
Lesson #3: Tilt away from large caps
The third and final way to avoid being too heavily concentrated in a small group of very large stocks is what we call portfolio tilting.
As we’ve explained, there are periods when it absolutely pays to be invested in the stocks that contribute the most to market returns. The two biggest stocks at the time of writing, for example, are Microsoft and NVIDIA. Since joining the S&P 500 in 1994, Microsoft has returned around 15,500%.
However, as research by Nobel laureate Eugene Fama and his research partner Kenneth French has shown, large growth stocks have underperformed smaller value stocks over the very long term. There is no guarantee that this will be repeated in the future, but there is a great deal of evidence to suggest that it will.
By holding a broadly diversified portfolio but also tilting it away from the largest stocks by investing in a small and value stocks you enjoy the best of both worlds. In other words, you benefit when small groups of large stocks like the Magnificent Seven dominate the markets, but you also perform well when small and value stocks come back into favour.
Wiser for next time
It can be very demoralising to read about past investment returns and discover how much better off you would’ve been if only you had invested in a different way. But this article is meant to help and inspire you.
Whether or not you benefited from the success of the Magnificent Seven is completely irrelevant. It’s extremely unlikely that the most successful stocks of today will also be the best performers in the future.
What matters now is that you learn from past mistakes and resolve to invest from now on in a sensible, efficient and evidence-based way.
Why not book a free consultation with rockwealth Wharfedale founder Mark Roe and set out on that journey today?
Financial Adviser and Financial Planner in Wharfedale
rockwealth Wharfedale is a fixed-fee Independent Financial Adviser situated in Wharfedale, North Yorkshire.About Us: Nestled in Wharfedale, rockwealth is your dedicated local financial planning firm. From tailored financial advice to pension and retirement advice, evidence-based investing, and inheritance tax planning, we are here to facilitate your financial journey in Wharfedale and the broader North Yorkshire area.
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