Diversification Still Matters in a Top-Heavy Market
Editor's note: Diversification has long been one of the most reliable ways to manage risk. But today, many investors' portfolios are unknowingly more concentrated than ever. In this issue – adapted from the free Chaikin PowerFeed daily e-letter – Joe Austin explains why index funds are failing investors... and why there are still strong stocks to choose from in this market.
It's one of the first principles every investor learns...
Diversification.
As the old saying goes, you don't want to put all your eggs in one basket.
The concept is simple: Spreading your investments around lessens the impact of poor performers and mistakes.
And historically, it has worked. In finance, diversification is the easiest way to reduce your risk without sacrificing return.
But lately, diversification has gotten a bad rap.
That's because tech has been such a runaway sector – led by the "Magnificent Seven."
Last year, those seven stocks posted an average return of more than 60%. That's more than double the S&P 500 Index's return of about 23%.
And the Magnificent Seven accounted for more than 50% of the benchmark index's return in 2024.
This year, they're still collectively having an outsized effect on returns...
Year to date, the S&P 500 is up around 12%. Over the same span, the Magnificent Seven have gained about 17%.
And if you're an investor buying into an S&P 500 index fund today, you're putting a lot of your eggs into that Magnificent Seven basket.
In July, the S&P 500's top 10 stocks reached a record concentration of 38%. But earlier this month, they ticked even higher to around 40%.
That's up from 16% back in 2014.
All this leaves investors with a tough choice...
If you're investing via an index fund, the very strategy designed to protect you from concentration has become concentrated itself.
Many investors were fine with that... as long as the Magnificent Seven worked.
But not all seven stocks are such big winners anymore.
Nvidia (NVDA), Alphabet (GOOGL), Microsoft (MSFT), and Meta Platforms (META) are up between 20% and 35% this year.
But Amazon (AMZN), Tesla (TSLA), and Apple (AAPL) have struggled... each underperforming the S&P 500.
So when you invest in an index fund today, you're buying some losers along with the winners in mega-cap stocks.
And you're doing so when concentration is near an all-time high.
This creates an opening for a different approach. It's one that lets you be more selective about which stocks deserve your money.
And rather than holding you back, let diversification be your way forward...
Plenty of Opportunity for Diversification in This Market
When I began my career on Wall Street, investors still had a hangover from the "Nifty Fifty."
You've probably heard the term before. It refers to a group of blue-chip growth companies that dominated the market's performance during the late 1960s and early 1970s.
Common wisdom then was that it didn't matter what price you paid for these stocks. That's an eerie parallel with today.
At the peak of this frenzy, Polaroid traded for around 90 times earnings. Xerox, IBM, and General Electric traded at multiples of roughly 30 to 40 times earnings.
And when the bear market of 1973 and 1974 struck, the Nifty Fifty didn't just underperform... some lost 80% to 90% of their value.
For an investor, that's a horrible loss to bear.
But in hindsight, the Nifty Fifty ended up doing just fine.
In 1998, Jeremy Siegel – a professor at the Wharton School – performed a post-mortem on the Nifty Fifty. He calculated those stocks' peak valuations to determine whether the valuations were justified.
And Siegel proved that had you held on, your performance would've been roughly in line with the market.
And Siegel also showed that most Nifty Fifty valuations made sense. Yes, they were rich. But the companies ended up growing into those valuations.
As he showed, the sell-off was mostly a result of a change in investor confidence.
That's another benefit of diversification. It doesn't just protect your portfolio... It protects your psychology, too.
By spreading your investments across many stocks, you can weather inevitable storms without panicking at the worst possible moment.
Investors who bailed out during the crash missed the recovery that made those stocks worth holding after all.
Today, we obviously can't know exactly where the Magnificent Seven stocks will end up in the future...
But we have our Power Gauge to help guide us. This is a tool we use at Chaikin Analytics to gather a wide array of investment fundamentals, technicals, and more into a simple, actionable rating such as "bullish," "neutral," or "bearish."
Right now, three of the Magnificent Seven are "bullish" or better in our system. And the other four are in "neutral" territory.
Fortunately, the Power Gauge also sees plenty of big opportunities in other corners of the market. It currently rates nearly 600 stocks "very bullish."
So when it comes to stocks with the potential for strong performance ahead, there are lots to choose from in this market.
The key is finding the right mix that lets you sleep at night while still benefiting from what's working in the market.
The Nifty Fifty taught us that great companies can withstand terrible valuations... if you can survive the ride.
And diversification makes that ride bearable.
Good investing,
Joe Austin
Editor's note: Marc Chaikin, founder of Chaikin Analytics, just issued an urgent warning for October 3. He says there's an abrupt and surprising shift coming for U.S. stocks...
The last time he issued a similar warning, tariffs triggered a 19% drop in the market. But Marc helped investors avoid the Liberation Day sell-off, identify the bottom, and get back in for the major rebound that followed.
Now, Marc says his groundbreaking strategy can help investors capture big, quick gains again. Learn here why you must move your money ahead of the next great market crash...