The current focus on the “Magnificent Seven” stocks and their outsized market impact raises fundamental questions about market concentration in equity returns. This phenomenon, far from unique to the current era, reflects deeper patterns in stock market performance. The issue is the concept of equal weighting indexes vs. market capitalization weighting.
Equal weighting is a hot topic now because of the valuation of the largest companies in the index. As noted in last month’s blog, just seven stocks accounted for over 50% of the S&P 500 return in 2024 and make up nearly 60% of the Russell 1000 growth index. There is certainly a place for equal weight indexes. Should investors abandon market cap weighting in indexes? In short, no.
Why? History tells us that market-cap weighting adds value because a relatively small number of stocks have accounted for much of the returns over the past 100 years or so (see study below). We can’t predict which stocks will be the big winners in the future. But by investing in broad, market-cap-weighted indexes, we “let the winners run,” which tends to be advantageous. Rebalancing to equal weight can mean reducing exposure to those winners. The legendary Fidelity Magellan manager Peter Lynch famously compared this to “pulling out the flowers and watering the weeds.”
A seminal study* by Professor Hendrik Bessembinder of Arizona State University’s W. P. Carey School of Business also provides compelling empirical evidence on this topic. In “Wealth Creation in the U.S. Public Stock Markets 1926 to 2019,” Bessembinder analyzed the lifetime returns of 29,078 common stocks traded on major U.S. exchanges, revealing patterns that challenge conventional wisdom about market returns and portfolio construction.
The Concentration Effect
The data from the study demonstrate a remarkable skewness in wealth creation:
- Significant Skew: Just 86 companies—less than 0.3% of all listed stocks—accounted for half of the total wealth created in the stock market over nearly a century.
- Top Performers: Only the top 1,000 stocks generated positive wealth creation over risk-free bonds.
- The Rest: The remaining 96% merely matched one-month Treasury bill returns.
- Mean vs. Median: A dollar invested across all stocks grew to $229.40 by the end of 2023 (an average return of 22,840%). However, the median stock actually lost money.
- Negative Returns: 51.6% of stocks showed a negative return of 7.41% over the 98-year span—significantly underperforming inflation, which grew by 1,614% (2.94% annually) during the same period.
Practical Implications
These findings have practical implications for both investment theory and practice. First, as noted, market-cap-weighted indexes allow the top-performing stocks to drive returns, enabling the best-performing stocks to add value over time. As such, these indexes serve as an essential low-cost building block for a portfolio. While active management may not be as well-positioned to capture the relatively small number of stocks that drive the majority of returns, as a market-cap-weighted index can, it still offers value. For example, active management allows investors to diversify across a broader base of stocks and invest in less efficient asset classes such as alternative investments, small-cap stocks, and international equities.
Key Takeaway: Broad Market Exposure
While major financial institutions currently project moderate returns for the coming decade, Bessembinder’s research suggests that maintaining broad market exposure is crucial for capturing returns from transformative companies. The recent performance of Nvidia, for example, shows how a single company can significantly impact overall market returns, reflecting the historical patterns documented in the study. This balanced perspective acknowledges both the academic rigor of Bessembinder’s findings and their practical implications for modern investors.
At Sunpointe, we believe that successful long-term investing requires:
- Understanding historical market return patterns
- The discipline to maintain broad market exposure through different market conditions
That’s why we’re here to help. Please contact us if you have any questions or would like to discuss topics like this further.
