Tech stocks have a bright future but things can change, making diversification essential
- Over-concentration in tech stocks can lead to a lack of diversification, as the performance of these stocks is often correlated.
- While stocks have historically outperformed other asset classes, future returns are uncertain, and diversification can help mitigate risk.
Investors don’t often get a second chance to get things right. But they might have received that opportunity with the ongoing rebound of the "magnificent seven" stocks, following a plunge last month.
As the dust settles, things look better for these giant, tech-centered companies, despite the emerging threat posed by DeepSeek, an artificial intelligence competitor from China.
The significance isn’t only that the AI battleground has become more competitive for American companies. Another lesson is that it can be hazardous to concentrate one's portfolio in a relative handful of stocks that share many of the same characteristics. That lack of diversification subjects investors to more risks than they think they're taking.
When stock prices are rolling, it's easy to forget about diversification, and the magnificent seven companies have caught the attention of investors for good reasons. They are industry leaders, they’re harnessing AI and other advanced technologies and they're giant companies, each worth more than $1 trillion.
Their hot streaks might last for years to come. But as a group, they aren’t diversified, and mainstream investors should recognize this.
“Don’t get caught trying to overweight just to those seven stocks,” said Mark Matson, head of Scottsdale investment firm Matson Money, during a Jan. 14 interview on Fox Business Live. “You got to diversify because nobody knows with a crystal ball what will happen.”
While Matson urges investors to own stocks, he suggests adding small companies, foreign stocks and other types to the mix, along with corporations that operate in different industries — not just tech.
They might be magnificent, but they aren't diversified
The seven magnificent companies are, in order of recent value, Apple, Microsoft, Nvidia, Amazon, Alphabet (Google’s parent), Meta (Facebook’s parent) and Tesla.
Some investors add another tech giant, Broadcom, to the mix to form the "big eight." Some of these aren’t primarily tech corporations. Amazon is a retailer and Tesla produces cars. But their operations are so digitized and advanced that their shares trade like tech stocks.
Assuming you hold much of your money in a stock fund that tracks a broad grouping like the Standard & Poor’s 500 index, you’re properly diversified, right? Not necessarily.
You would think that this index, composed of 500 stocks, would be broadly diversified. But roughly 33% of the index’s returns currently come from movements in the magnificent-seven stocks, or 35% if you include Broadcom, according to DataTrek Research. In fact, the S&P 500 is so tech-heavy right now that it’s trading in close lockstep with the Nasdaq 100, a traditional tech-dominated index.
This presents another portfolio check-up opportunity that investors should consider, if they own funds pegged to both the S&P 500 and Nasdaq 100.
“There’s little diversification benefit to owning both the S&P 500 and (Nasdaq 100),” wrote Jessica Rabe, co-founder of DataTrek Research. That means the next time big tech stocks get clobbered, both indexes likely will go down together.
Realistically, you should own at least a couple dozen different stocks to get even minimal diversification, and that assumes you are holding companies in different industries and of different sizes — not just large but medium and small stocks as well. Funds can help you diversify, but not always.
Adding different assets to the mix
Potentially low diversification among stocks is only part of the problem.
To ensure an overall smoother ride with some downside protection, you also should include different types of assets. Bonds and cash (Treasury bills, for example) are considered very good diversifiers to an all-stock portfolio, but you also might want to include other investments such as REITS or real estate investment trusts, gold and funds that hold commodities.
On the stock side, you could gain further diversification by including foreign stocks or funds pegged to developed economies like Canada, Japan, the United Kingdom and Germany, along with those from emerging markets such as China, Brazil, Taiwan and South Africa.
Over the long haul, large stocks as represented by those in the S&P 500 have handily outperformed both bonds and cash, delivering an average annual return of 8.4%, compared to 4.7% for bonds and 4% for Treasury bills, according to researcher Wilshire Associates.
But looking ahead, with stocks highly valued after last year’s surge, Wilshire anticipates much lower results ahead: The company is forecasting an average annual return of just 4.4% for stocks, 5.2% for bonds and 3.6% for T-bills over the next decade.
Like other forecasts, that one might or might not pan out. But if you’re worried about the longevity of the stock market’s surge — or fear you couldn’t stomach big losses — adding more diversification to your portfolio could be a shrewd move.
Reach the writer at russ.wiles@arizonarepublic.com.