Concentration Works Both Ways

Ian Tam: Despite a bleak economic outlook, in August, the S&P 500 not only recovered from the COVID-19 dip, but it's actually surpassed its previous highs. Many say that this is due to the outperformance of technology stocks. Today, we'll have a look at how true that actually is.

This first chart shows the five stocks that make up almost 25% or a quarter of the S&P 500 Index. These stocks include Apple, Facebook, Amazon, Google, and Microsoft. To understand the impact of these stocks on the index's performance, I use Morningstar CPMS to run a back test with the intent of replicating the index but without these five stocks.

Here are the results. Without the five largest companies and counting both share classes of Google, the S&P 500 would have still recovered to pre-pandemic levels but would have been a full 6% lower in value assuming that we invested at the end of January.

So, what about Canada? In Canada, the S&P/TSX Composite is made up of about 221 stocks, and, similar to the S&P 500, it's also market-cap-weighted, meaning the largest companies tend to have a larger influence on the performance of the index. In Canada, energy companies represent 11% of our index. What do you think would happen if we had excluded energy companies from the index during the pandemic?

If we excluded the energy sector altogether, the TSX Composite would have actually recovered back to its pre-pandemic highs and would have been about 6.2% higher in value at the end of July--again, assuming that we started investing at the end of January.

The point here is that market concentration works in both directions. As a retail investor, you want to keep a very close eye on how much of your investment is in a single sector or a single stock. That way you're not met with the unnecessary risk that can be reduced by simply ensuring you have a well-diversified portfolio.

For Morningstar, I'm Ian Tam.