The missing ingredient in today’s large-cap allocations: value stocks

As of the close of 2023, these seven stocks represented just under 30% of the S&P 500 Index’s (S&P 500’s) total market capitalization. This is uncharted territory. Over the past 40 years, the seven largest stocks in the bellwether index rarely accounted for more than 20% of its market cap. The performance record behind these seven names is even more disproportionate. Last year, the Magnificent Seven gained more than 100%, while an equal-weighted allocation to the S&P 500 returned just 14%.

There might be a silver lining to this tale if these seven stocks represented a broad cross section of the economy. They do not. All seven are growth stocks, all are technology-focused companies, and all recently had valuations (as measured by forward price-to-earnings ratios) higher than the S&P 500 itself—in some cases, two or three times higher.¹

Extreme concentration, high valuations, sector bias—the risks are significant and, in many ways, mounting. But that doesn’t mean investors are without recourse. We believe investors can counteract some of the most pronounced challenges in today’s equity market by refocusing on first principles.

Cast a wide net: seek to proactively mitigate today’s market concentration risk

To spell out the problem behind concentration risk even more explicitly, a targeted allocation focusing on any narrow segment of the stock market is unlikely to pay off with any consistency. We can clearly see this in action by looking at the S&P 500’s underlying sector performance over the past 15 years. It’s frequently been the case that a top performer one year will be at the bottom of the pack the next, or vice versa. Case in point: Information technology was the top performer last year but one of the market’s worst-performing sectors in 2022.

None of this is to suggest a bias against tech stocks or any other segment of the market. Our concern has more to do with the idea of intent. Investors with allocations to large-cap growth strategies would expect to see these seven stocks represented in their portfolios in meaningful ways. The problem, we believe, lies with investors in passive large-cap strategies and even in many actively managed large-cap core strategies.

For these investors—who would rightly expect their investments to offer broadly diversified exposure to the most dynamic economy in the world—something approaching one-third of their allocation is targeting a single, homogeneous, and relatively expensive segment of the stock market. Fortunately, this is a problem with a simple, time-tested solution.

Diversify with purpose: dedicated allocations to growth and value strategies may help prevent chasing yesterday’s top performers

We believe there’s a fairly easy way to counteract today’s extreme levels of concentration risk: a dedicated allocation to large-cap value stocks. How to implement such an approach is open to debate, but the pitfalls deserve review. Passive and core-based approaches in today’s market are heavily weighted in favor of growth stocks in general and the Magnificent Seven specifically. In fact, essentially any approach oriented toward the S&P 500 or the Russell 1000 Index would tend to overexpose investors to these seven securities due to their disproportionate representation in those indexes, and continued strong performance in the tech sector would only compound the problem.

For that reason, we believe it may be more prudent to target those types of tech-oriented holdings intentionally through a large-cap growth allocation—and then, with equal intention, to diversify away from those securities through a large-cap value position. This two-pronged approach is about as straightforward a way of dealing with concentration risk as there is: Exposure to, and reliance on, the Magnificent Seven would immediately be reduced significantly.

Such an approach also eliminates some of the temptation to chase yesterday’s top performers. Consider that over the past 45 years, growth and value have traded market leadership positions 27 times.

It’s worth pointing out that this 45-year snapshot reflects a period of relative parity between growth and value investment styles: The Russell 1000 Growth Index returned 11.96% per year during this time frame while the Russell 1000 Value Index returned 11.57%. This hasn’t always been the case, and there are two realities that deserve addressing head on: first by looking at more recent history and then by taking an even broader view of the landscape. To begin, it’s true that since 2007, growth stocks have tended to outperform value stocks—why is ultimately a matter for another paper. The second point is to highlight what an anomaly the past decade-plus has been. Looking back to 1927—and including those recent years of value’s relative underperformance— value has still outperformed growth by an average of more than 4% per year. And in those calendar years where value does outperform, the difference has been huge: nearly 15% on average. More than just a source of ballast, value stocks can offer meaningful alpha to a diversified portfolio.

Buy low, sell high: dollar cost averaging and regular rebalancing may help investors stay diversified and reduce volatility

One of the underappreciated risks associated with any concentrated exposure is behavioral: Investors tend to have a fairly low tolerance for volatility. Every year, Morningstar calculates the average return for various asset classes and compares those figures with the dollar-weighted returns. The result, invariably, is a gap—the difference between the returns investors actually achieved and the more hypothetical performance any given category produced.

Morningstar found that volatility consistently undermines investor returns, both across categories and within. For example, allocation funds—which generally exhibit less volatility than equity strategies—posted a significantly smaller return gap over the past 10 years than several equity categories. The gaps within categories track volatility as well. U.S. equity funds with higher standard deviations experienced larger gaps than those that were relatively more stable. Per Morningstar, “the general trend makes intuitive sense, as funds that expose investors to less volatility should be easier to own and less prone to erratic cash flows, thus leading to better investor results.” Ultimately, volatility isn’t a problem in itself—it becomes one when it motivates investors to lock in losses or, on the upside, to buy into market peaks. A lower volatility profile within a U.S. equity allocation isn’t simply a means to help investors feel better; it can actually enhance long-term returns.

Defined contribution plans are an ideal setting for helping investors to put such a program into action. The nature of dollar cost averaging acts as a check on over- allocating to the priciest parts of the market, while many plans’ automatic rebalancing features can help keep investors’ portfolios appropriately diversified. By way of reminder, dollar cost averaging is one of those rare investing concepts that acts like more of a law of physics: When buying any variable quantity of something—whether it’s shares of a mutual fund or gallons of gas—if the dollar investment is fixed, you’ll end up buying more of it when it’s cheap and less when it’s expensive. The result over time is to drive down the cost basis, which is the key to any successful long-term investment strategy.

Price matters: seek the lowest cost basis

We hope by now it’s clear that the reports of value investing’s demise have been greatly exaggerated. There’s no shortage of evidence to demonstrate that lower relative prices lead to higher prospective returns. We believe value stocks remain a meaningful source of alpha and that investors would be remiss to pass over the opportunity, especially given the inherent concentration risks involved in any strategy that doesn’t expressly incorporate value stocks into a portfolio.

For those investors who may have grown skeptical of value investing’s potential or have inadvertently seen their portfolios tilt toward growth, now may be the perfect time for a reexamination: Our own research suggests that we may be in the early innings of a market leadership pivot away from large-cap growth toward large-cap value. But again, rather than shoulder the impossible task of trying to time such a transition, we believe investors are better served by owning both growth and value stocks throughout various market regimes—and to hold them in roughly equal proportions by rebalancing regularly.

There is some urgency to act: When the tech-led sell-off began in late 2000, it took just 12 months for the Russell 1000 Growth Index to lose more than half its value.² While we certainly can’t predict the future, it’s worth considering that with seven stocks making up such an outsized portion of the market—and, consequently, of many investor portfolios—a reversal of fortune or spike in volatility in just three or four of those companies could have dramatic consequences for investor returns. We believe that’s the kind of risk most long-term investors would gladly avoid.

1 FactSet, as of December 31, 2023. 2 Bloomberg, FTSE Russell, 2024.