The market’s over-reliance on a few giants is skewing risk-reward dynamics, squeezing your margin of safety to a razor-thin line. High valuations, shrinking diversification, and misplaced capital challenge investors to rethink conventional strategies.
Risk.
It is the crucial and unavoidable half of the investment scale.
As investors, we are first and foremost risk managers, because the law of large numbers applies. When you lose 10%, you need to earn 11% to break even. Once you move towards a 30% loss, the point of no return, the problem moves exponentially against you. Losing 50%, for example, mirrors the famous 100% profit required to break even. So, the first question you should ask yourself with any investment is what could go wrong. Not to mention that you should always avoid big and obvious risks. As for the latter, there’s one obvious risk I have already covered in depth that keeps me awake at night. It is the 15-year-old idea of persistently buying only the largest stocks by market capitalization for no other reason.
We are reaching a turning point. For years, it paid to follow the market. Free riders were able to profit from the capital allocation of so-called “smart money” investors. But what happens when the followers gain the upper hand, as is now the case? A crowded trade that is mindlessly becoming even more crowded. In other words, capital allocation is no longer efficient and is no longer determined by fundamentals but by size. The result is that market participants are investing more capital in the largest companies due to increasing market concentration, even though these companies are no longer growing in line with the underlying fundamentals.
And that significantly worsens the other half of the investment scale.
Your reward.
Chart 1: Valuation, Weight and Earnings Contribution of the Top 10 in the S&P 500
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