There’s been plenty of publicity in recent months about the Magnificent Seven. No, I’m not talking about the classic Western starring Yul Brynner, Steve McQueen and Charles Bronson, but the seven big technology firms that have been dominating the US stock market: Alphabet (Google), Amazon, Apple, Meta Platforms (Facebook), Microsoft, NVIDIA and Tesla.
Some commentators have warned that the success of these stocks has made indices like the S&P 500 too heavily concentrated. But, historically, it’s not unusual for a small number of stocks to dominate an index. And, as new research by Vanguard demonstrates, investors who held the Magnificent Seven stocks in their portfolios have been amply rewarded. The researchers found that a simulation of the Russell 3000 Index without these seven companies would have lagged the back-tested Russell 3000 Index by approximately 2.1% per annum over the ten-year period to the end of 2023.
Interestingly, though, that same Vanguard study also found that it isn’t always so beneficial to own all of the biggest stocks. The researchers looked at returns over a 24-year period from the start of 2000. Although it appears to have been more important to hold the stocks that made the biggest contribution to index returns in recent years, it was actually more impactful the stocks that made the biggest contribution in the early years of the study.
Why was this the case? The reason, says Vanguard, is that up until 2014, small-cap stocks outperformed large-cap stocks. After 2014 that trend reversed.
“If large caps underperform small caps,” the study’s authors explain, “the gain from not holding the bottom performers tends to exceed the loss from not holding the top contributors. Conversely, if large caps outperform small caps, the loss from not holding the top contributors tends to exceed the gain from not holding the bottom contributors.
“Hence, the ‘direction of travel’ is, to a significant extent, determined by large-cap stocks.”
So what lessons, if any, can investors learn from this research? And how can they avoid being over-exposed to a small number of large stocks?
© The Evidence-Based Investor MMXXIV. All rights reserved. Unauthorised use and/ or duplication of this material without express and written permission is strictly prohibited.