Keeping too many eggs in one basket can be costly if the basket tips over, especially with today’s egg prices. The same principle applies to investing in financial assets, and even those purchasing a broad basket of stocks such as index funds may find themselves with a top-heavy dollop of risk that they had not bargained for in a market where prices are far from attractive, even after recent declines.
Diversification is a fundamental principle of investing applying to all types of vehicles, but especially stocks. Unlike bonds, stocks provide no fixed, contractual return. Because their ultimate results depend on the progress and prospects of the enterprise, a certain amount of judgment must be exercised in their selection. Equities are “risk assets” representing ownership interests in business organizations, the basic building blocks of our capitalist economy; over time and in the aggregate, they have done quite well for their owner/investors as the economy grew. However, this overall record of success masks individual failures in which hapless shareholders have lost all of their commitments; diversification—allocating money to a variety of different enterprises—helps avoid being wiped-out by a single investment gone bad. Diversification is critical for the investing public whose members typically lack the time or interest to immerse themselves in the study of potential investments. For most people, an average result achieved through exposure to a broad group of businesses is sufficient.
Innovations over the last few decades have made investing easier for non-professionals. For example, so-called “passive” investment vehicles designed to replicate the market returns of securities represented by an index such as the S&P 500 have experienced strong growth in assets as individuals—and institutions—have become aware of their advantages. In general, this is a very positive development for individuals, as index funds are inexpensive, offer the possibility of broad diversification, and are easily understood. When used properly over a person’s lifetime, such funds can enable the accumulation of substantial sums.
Unfortunately, the diversification benefits that attract investors to passive vehicles also create vulnerabilities due to the market capitalization-weighted structure of most funds: when the market itself becomes unbalanced in a way that favors a narrow group of securities, investors are exposed. Regretfully, it is precisely at such times that more investors are attracted to equity investments as the excitement surrounding a favored industry draws in more participants. Recent history offers important lessons in this regard, especially in 2000 when market averages collapsed due to overexposure to a small number of technology shares. In the years since the Financial Crisis, the returns produced by the US stock market have been skewed yet again by the explosive rise in market value of a small group of high-tech companies: currently the “magnificent seven” that have been boosted by artificial intelligence (AI) hype. Since index funds must “own the market,” they, too, have become dominated by “big tech” to an unusual degree; about 30% of the value of the S&P 500, for example, is comprised of six or seven tech stocks. Investors seeking diversification are, in fact, concentrating a large portion of their dollars in volatile, arguably over-priced companies in a single economic sector.
In recent years the problem of concentration in investing has taken on a new wrinkle. Some years ago research indicated that spreading equity investments among international markets was a good way to achieve broad diversification and possibly increase returns on investment. Early adopters did well with the strategy, prompting others to follow, and eventually global indexes and funds based on them were created to channel funds into the sector. But, as outlined recently in the Financial Times, the same phenomenon of concentration seen within the US has now come to characterize the international investment scene. Like the US versions, most global indexes are designed to reflect the relative market values of their components, in this case the constituent countries. Since the US has the largest equity market in the world, accounting for two-thirds of global equity values, it is the biggest single target of global index money. So, in addition to creating risks for domestic index investors, the vast run-up in valuations in US tech shares means that investors in global index funds face the same problem of concentration—in this case in a single country and economy—due to inflated stock market values of a small number of companies.
Aside from the questionable wisdom of over-concentration in a few volatile assets, heavy allocation to the US also conflicts with the need for diversification among political and currency risks when investing globally. This comes at a time when the notion of American “exceptionalism” is being called into question by both domestic and foreign investors. The country has long been a financial haven due to its economic stability and adherence to legal norms, and it has benefited greatly from this status; US currency dominates world trade (at 88% of foreign exchange transactions) and the US easily attracts foreign investment. Moreover, the country’s large fiscal deficits (some would say profligacy) have so far been readily financed on relatively favorable terms. Currently, however, some well-off Americans are putting money into gold or foreign properties as hedges. Some large institutional investors, such as pension fund managers, are also beginning, quietly, to wonder whether the US will continue to be the safe haven they have known during their entire careers—unlikely to change soon, perhaps, but fiduciaries have to ponder worse case scenarios rather than just hope for the best. Given the massive position of the US in international finance, it’s unlikely that investors will flee the country en masse, but it is one more reason for buyers to beware putting too much money into one place.
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We have little interest in the workings of “crypto,” nor do we understand why anyone would view something that sells for between $20,000 and $100,000 over a matter of months as a stable store of value, aka “currency.” Not even gold is subject to such wild swings, and at least the yellow metal has the advantage of thousands of years of experience, not to mention actual uses in jewelry or as an electrical conductor. Where cryptocurrencies have found a home is among criminals who use them to hide drug-dealing and money-laundering transactions. Others have discovered their value as breathtaking tools of speculation or grift.
We were flabbergasted to learn recently that some important players in the institutional investment industry are now viewing crypto as a possible “investable asset class.” Indeed, foundations and endowment funds appear to be taking crypto commitments beyond the “experimental” stage.
Securities go through a “seasoning” process in which, in the case of stocks and bonds, an issuer proves its earning power or management capability over time and investors’ confidence increases accordingly. So-called crypto assets are wholly lacking in such attributes. The current buzz is a “FOMC”—fear of missing out—phenomenon in which institutional managers see competitors benefit from wagers on something new and untested (one is said to be “green with envy” for a reason). As one chief investment officer said: “we don’t want to be left behind when [crypto’s] potential materializes dramatically.” Another had no plans to get involved until “more of his established peers jumped in…”
Perhaps these big investors have so much money that they believe they can afford to risk losses on an occasional speculative bet. To us it is a sad day when members of an industry with “investment” in its name engage in speculation, just because “everyone else” is doing it. In fact, one of our cardinal rules is: in investing, it’s never a good idea to do what “everyone else” is doing.
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Many shall be restored that now are fallen and many shall fall that now are in honor . Thus began the most highly regarded treatise on investing ever written, Graham and Dodd’s Security Analysis. A more poetic version of our cardinal rule stated above, this principle was on full display during the first quarter as the collective avatar of American market “exceptionalism,” the “Magnificent Seven,” fell heavily from favor. As we write, an index of these stocks has lost 15% since the beginning of the year. One of the group, Tesla, lost fully 50% of its market value at one point, and the action in this small group of companies helped to drag the broad US stock market into a 10% “correction” in March.
The decline was not especially notable as far as market fluctuations go, and given all of the chatter about economic anxiety, trade wars, and stagflation, it actually seems modest. Nevertheless, the change in market sentiment from the rampant bullishness that had erupted towards year-end 2024 was remarkable, and it was reflected in actions taken by big investment funds. A March survey of investment managers found that the proportion of their money invested in US equities dropped by the “biggest ever” amount in the new year (while, at the same time, individual punters poured in tens of billions of dollars, following online promoters cheering “buy the dip!”). European stocks were among the beneficiaries of the shift in “concentration risk” (the prior heavy institutional allocation to US securities). Long laggards, European markets have done far better than their US counterparts in 2025, rising about 9% versus a loss of 4% in the US as we write. Sooner or later, the fallen rise.
Dennis Butler, MBA, CFA
Commentary