Magnificent 7 and concentration risk

GazzaBloom

I hold equity index funds and don't worry about concentration risk, the stock markets have a long history of a few companies leading the indexes. Rotations will happen and Microsoft and Apple will one day fall down from the top the S&P500 and other companies will take their place, hold the index and are already holding the next winner.

Buy, hold, set, forget, accumulate! (as the Daleks used to say)

Linton

jimjames said:

Cus said:

I just feel uncomfortable relying on 7 massive (and historically at very high P/E ratios) companies to control 25%% of the investment. It feels like an active decision to invest passively as you are making a call that those 7 will continue to perform at or better than the rest though 

If they do badly and another company takes their place then by holding a tracker you'll benefit from that gain as a result of holding that index tracker.

Sadly it is not true that indexes are ranked by performance.....

If we assune that the S&P 500 is a perfect market, which does seem to be very pretty much the case, all shares will be set a price that the market believes will give the same future % returns.  If the market believed that investing £100 in share A would give a higher return than investing the same money in share B then B would be sold and A bought reducing the price of B and increasing the price of A  thus removing the disparity.

That should mean that there is no benefit gained by purely holding the largest companies.  Those companies are larger because they issue more shares not because they will give you the highest % returns.  One can and  should therefore focus on diversification

One can see that different allocations within the S&P500 has little long term effect by comparing the performance of an equal weighted S&P 500 index witrh a standard cap-weighted one.

Hoenir

jimjames said:

Cus said:

I just feel uncomfortable relying on 7 massive (and historically at very high P/E ratios) companies to control 25%% of the investment. It feels like an active decision to invest passively as you are making a call that those 7 will continue to perform at or better than the rest though 

If they do badly and another company takes their place then by holding a tracker you'll benefit from that gain as a result of holding that index tracker.

The 7 though aren't going to drop out of the index anytime soon. As long as they remain profitable they'll continue to be constituents of the index. A new entry to the index isn't going to influence the S&P500 greatly even if it rises by 20%.  

JohnWinder

That should mean that there is no benefit gained by purely holding the largest companies.  Those companies are larger because they issue more shares not because they will give you the highest % returns.  One can and  should therefore focus on diversification.

You might be putting straw into men’s mouths. It is not the suggestion to purely hold the largest companies, rather as much of the market as is practical ie, diversified.

The large companies are large because their share price multiplied by shares issued is large, surely it’s not that they issued the most shares. Were it so I could own the largest company on the planet by issuing many more shares than Apple (or whomever it is); that no one would buy them surely counts for something?

One can see that different allocations within the S&P500 has little long term effect by comparing the performance of an equal weighted S&P 500 index witrh a standard cap-weighted one.’

As we often do, this seems to ignore risk. Have a look at the chart in the linked post. The risk of the equal weighted fund was higher, and its risk adjusted return was lower.

Grandst2

Index trackers are vulnerable to bubbles in the market like dotcom mania or Japan in the 80's when they were 45% of the global market. AI feels slightly bubblish so ETFs with extra filtering might be a good idea or a global all cap tracker putting less into these big tech companies.

adindas

Cus said:

If you invest in a market cap weighted index tracker, is it getting more and more risky having what effectively equates to 25% or more of your investment in 7 companies? 
I've read that most of 2023 S&P gains are concentrated in these 7 companies. Does that mean that it could actually be riskier to invest in a passive tracker versus an alternative fund that tries to minimise this?

Just wondering if the highly logical theories of passive tracker investing considered such concentrations?

It will depend on whether it is for long-term holding or short-term. For short-term analysis, various technical analyses, mainly focusing on the volume versus price, could be used. Examples of these are the CNN Fear and Greed Index, put/call options, various technical analysis indicators such as RSI, MACD, Bollinger Band, etc

Regularly scanning the news directly related to the stock in question such as share buybacks, share offering (dilution), stock splits, M&A, new products launch, etc, or global news such as inflation, interest rate, what the FED is doing, geopolitical situation.

For long-term holding, it should be combined with fundamental analysis, and valuation such as Free Cash Flow (FCF), ROA, ROE, and looking into various ratios such as P/E, P/FCF, P/B, P/S,  D/E ratio, etc. In many cases, these have been calculated on some sites. Another valuable metric is the Piotroski F Score, typically only available for paying subscribers. Additionally, it could be enhanced by examining what the proven billionaire investors are doing (buy/Sell?) and/or looking into Wall-street analyst price target.

There is quite a bit of information regarding this available in this forum. However, it should be kept in mind that none of these methods guarantee 100% accuracy, but they do provide a higher probability of getting it right.

The performance of Magnificent seven sofar:

GeoffTF

A sense of proportion helps here. I plotted the total returns since 2010 for Vanguard Global Small Cap Index Fund (MSCI small cap) and VWRL (FTSE global large and medium cap) on Morningstar. They tracked each other perfectly until the Covid crash. They were neck and neck in the middle of March this year. VWRL is now 9% ahead. If the market is completely wrong in believing that the top 7 have better prospects than the rest of the market, you might lose 9%. I do not believe that the market is completely wrong. It is much more likely that these stocks are over priced by less than that, if they are over priced at all. The market goes up and down, and the front runners change over time. The small cap fund has been outperforming over the last couple of weeks, so if you fancy a punt, you could bet on that. Alternatively, just sit tight. That is the strategy that wins in the long run.

adindas

jimjames said:

Cus said:

I just feel uncomfortable relying on 7 massive (and historically at very high P/E ratios) companies to control 25%% of the investment. It feels like an active decision to invest passively as you are making a call that those 7 will continue to perform at or better than the rest though 

If they do badly and another company takes their place then by holding a tracker you'll benefit from that gain as a result of holding that index tracker.

In my personal opinion, that is the main point why people are buying the index tracker.

This is an example where the index keep going up without the help of Magnificent seven.

https://www.morningstar.com/news/marketwatch/2023121276/something-remarkable-and-extremely-rare-happened-in-the-us-stock-market-on-monday

"All three major U.S. equity indexes finished at fresh 52-week highs, with the Dow Jones Industrial Average DJIA closing at its highest level in nearly two years. Yet not a single member of the "Mag 7" finished in the green. Instead, they were all deeply in the red, with every member of the elite group of megacap technology stocks finishing at least 1% lower, except Microsoft Corp. (MSFT)."

Linton

GeoffTF said:

A sense of proportion helps here. I plotted the total returns since 2010 for Vanguard Global Small Cap Index Fund (MSCI small cap) and VWRL (FTSE global large and medium cap) on Morningstar. They tracked each other perfectly until the Covid crash. They were neck and neck in the middle of March this year. VWRL is now 9% ahead. If the market is completely wrong in believing that the top 7 have better prospects than the rest of the market, you might lose 9%. I do not believe that the market is completely wrong. It is much more likely that these stocks are over priced by less than that, if they are over priced at all. The market goes up and down, and the front runners change over time. The small cap fund has been outperforming over the last couple of weeks, so if you fancy a punt, you could bet on that. Alternatively, just sit tight. That is the strategy that wins in the long run.

I agree that if you are diversified it does not matter much in the long term how you allocate your money.nYou can add an equal allocation ETF to your graph, again you should find it very close to the others.

However I thought that what had been suggested is that one only invests in the current 7 companies. How would that have worked out  if you had stayed invested with the top 7 companies of 20 years ago? Diversification matters.

Another factor to consider is the time frame. In the long run, if the market generally prices shares correctly, It won’t matter which ones you buy as any foreseeable potential good or poor performance is already priced in. However those of us who are already retired don’t have the luxury of being able to wait for the long time.