History has a way of repeating itself, especially in the stock market.

In the early 1930s, for example, the largest 10 stocks represented nearly 40% of the total market. Although this concentration dropped in subsequent years, the top 10 still held a significant portion of the U.S. market's total capitalization during periods in the ‘50s, ‘60s and 2000s. ¹

Riding a wave of enthusiasm for artificial intelligence and tech innovations, a new breed of high-flying stocks emerged in the market run of 2023. Dubbed "The Magnificant Seven," these leading technology providers were comprised of Nvidia, Meta, Tesla, Amazon, Alphabet, Microsoft and Apple. The group captured the imagination of investors and analysts alike, and in fairly short order, climbed into the market's upper echelons.  

Those anxious to ride growing market sentiment for popular blue-chip stocks, however, might want to take a step back. A big picture view reveals red flags about chasing hot mega-cap performers. 

According to data compiled by Dimensional Fund Advisors going back to 1927, the historical evidence clearly shows that stock runs into the market's top 10 haven't translated into sustained outperformance in most cases. In fact, after reaching the top, the subsequent returns of these large-cap companies often lagged the broader market.

The chart below illustrates such a view. For this study, companies were sorted every January by beginning-of-month market capitalization size to identify first-time entrants into the domestic equity market's top 10. The market was represented by the Fama/French Total US Market Research Index. 

While a concentration of market capitalization isn't a new phenomenon, it's one in which history warns investors not to assume relatively shorter-term dominance will translate into sustained superior performance. Instead, IFA's investment committee advises extreme caution during periods of seemingly heady returns by stock market giants.

Another skeptic is Wes Crill, who is Dimensional's head of investment strategies. In an earlier research note that still resonates with us, the veteran market researcher pointed out that fund investors need to approach skyrocketing stocks with a good deal of patience and reserve. 

The "eye-popping returns" that too frequently feed trading frenzies "tend to occur before they reach the top of the market," he cautioned. Crill added, though, "once there, subsequent returns tend to lag the market." ²

The allure of the mega-cap stocks is undeniable. These are companies at the forefront of technological innovation and market leadership. At the same time, investors shouldn't lose sight of the broader market dynamics and the lessons of history. Chasing performance can often lead to disappointment when the giants of today do not live up to their expected potential tomorrow.

At IFA, diversification remains a cornerstone of prudent investing. An over-reliance on a few high-performing stocks can leave an investment portfolio exposed to unnecessary risk. Instead of chasing the performance of the moment, investors would do well to focus on a long-term, diversified strategy that balances potential returns with acceptable levels of risk.

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Footnotes:

1.) Dimensional Fund Investors, "Large and In Charge? Giant Firms atop Market Is Nothing New," June 17, 2020

2.) Dimensional Fund Investors, "Magnificent 7 Outperformance May Not Continue," Dec. 7, 2023.

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