The stock market is becoming more concentrated, especially in the United States, with US equities representing over 60% of the world's investable free-float capitalization. This concentration is also seen in other international markets.
Diversification, which is often seen as a risk management strategy, needs to be reevaluated as stock market concentration increases. Over-diversification can lead to diminished returns as investor insights and information are not fully utilized. This is known as "diworsification," highlighting the importance of a balanced approach to portfolio management.
Recent research shows that a small fraction of high-performing companies account for the majority of gains in the stock market. This is consistent across global markets. Active managers argue that their expertise is necessary to identify these high-performing stocks, while passive managers believe a diversified portfolio is needed to capture the overall market risk premium. The debate between active and passive investing strategies is complex and hinges on whether active managers can consistently identify these stocks after accounting for fees.
Historically, global diversification has been advocated as a strategy to mitigate risk for US investors. However, recent analysis suggests that focusing solely on the US market would have yielded better results due to the exceptional performance of US equities and the relatively low volatility of the US market compared to non-US markets. The benefits of global diversification may vary in the current investment climate.
Correlations between different countries' stock returns have increased, reflecting the growing interconnectedness of global economies and markets. This may diminish the potential benefits of diversification as the assumption that diversifying across countries reduces risk becomes more complex. The changing landscape calls for a reevaluation of diversification strategies.
In summary, the concentration of stock markets, the active versus passive investing debate, the complexities of global diversification, and the changing correlations among markets all contribute to a challenging investment landscape. Investors must navigate these dynamics with a keen understanding of the risks and opportunities ahead.