Concentration is a good thing when you’re applying it to work or studies or any other focused activity. But in the world of investing, it can expose you to higher risk of losses. If you were investing in the early 2000s, you might have seen this firsthand when the dot-com bubble burst. For investors who were highly concentrated in tech stocks at that time, the lessons were very painful.
You run into concentration risk when you invest heavily in a few stocks or bonds, or a single sector or even a single country. Should those parts of the market stumble, your portfolio’s value will too – at least on paper.
Understanding concentration risk in stocks: the Magnificent 7
In today’s markets, many investors are drawn to invest in the Magnificent 7 tech stocks: Nvidia, Apple, Microsoft, Google/Alphabet, Amazon, Meta and Tesla. Most of these companies have a market cap1 close to the entire size of the S&P/TSX. This highlights how much power they have to move the dial of markets. As they rise and fall, so do the markets. And if you invest heavily in them, so will your portfolio.
Comparing the top S&P 500 companies by market cap
Source: Bloomberg, RBC GAM. As of July 15, 2024. Measured in $billions.
1As a refresher, market capitalization is calculated by multiplying the number of shares outstanding by the price per-share. This means that the larger a company’s market cap, the more impact it has on a cap-weighted index. Source: Bloomberg, as of June 30, 2024. Percent of world market capitalization of listed domestic companies.
Understanding concentration risk in the Canadian stock market
As great as it is to travel in Canada, Canadian travelers know when they visit other countries, they’ll enjoy an even wider range of experiences. The same holds true for Canadian investors. Canada represents only 3% of capital markets in the world.1 The other 97% of investment opportunities lie in other regions. This means more opportunities to diversify, which ultimately leads to a smoother investment experience. Because when one region is performing poorly, another could be enjoying stronger performance. So your results are more likely to remain steady even if markets shift.
The chart below shows that investing too narrowly in any single country like Canada can lead to a bumpier ride when compared to a geographically diversified portfolio. And if, like many investors, you don’t stay the course, it could limit your returns or lead to lower returns.
Performance of stock markets by country over the last four decades
| 2020s | 2010s | 2000s | 1990s | 1980s | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Korea | 45.2 | New Zealand | 12.1 | Brazil | 14.7 | Sweden | 18.9 | Sweden | 29.7 | ||||
| China | 43.5 | USA | 11.2 | Australia | 10.7 | Switzerland | 17.4 | Japan | 28.7 | ||||
| Taiwan | 42.0 | Switzerland | 9.3 | Norway | 10.2 | Brazil | 17.1 | Italy | 22.9 | ||||
| Sweden | 24.4 | Taiwan | 9.2 | Korea | 8.9 | USA | 16.1 | Spain | 21.3 | ||||
| New Zealand | 20.2 | Sweden | 7.8 | Canada | 8.2 | United Kingdom | 14.2 | United Kingdom | 19.3 | ||||
| USA | 19.2 | Japan | 6.9 | New Zealand | 6.8 | Spain | 14.2 | Equal weight portfolio | 18.2 | ||||
| Japan | 14.9 | France | 6.1 | Switzerland | 4.9 | France | 13.5 | France | 17.6 | ||||
| Switzerland | 12.8 | Equal weight portfolio | 6.0 | Equal weight portfolio | 4.2 | Germany | 12.9 | Germany | 16.7 | ||||
| Germany | 12.3 | Germany | 6.0 | Spain | 3.9 | Equal weight portfolio | 10.0 | Australia | 13.9 | ||||
| Equal weight portfolio | 9.7 | Korea | 5.6 | Sweden | 3.2 | Canada | 9.8 | Norway | 12.9 | ||||
| Australia | 8.9 | Australia | 5.2 | United Kingdom | 1.6 | Australia | 8.6 | Switzerland | 12.3 | ||||
| Canada | 6.2 | United Kingdom | 5.1 | Germany | 0.7 | Italy | 8.4 | USA | 12.1 | ||||
| Italy | 2.4 | Canada | 4.3 | France | 0.4 | New Zealand | 5.0 | Canada | 11.7 | ||||
| Norway | -0.9 | Norway | 3.3 | USA | -1.5 | Taiwan | -0.3 | ||||||
| Spain | -4.5 | China A | 2.4 | Italy | -1.6 | Japan | -0.7 | ||||||
| United Kingdom | -10.4 | Italy | 0.8 | Japan | -3.0 | Korea | -0.6 | ||||||
| Brazil | -18.9 | Spain | -0.5 | ||||||||||
| Brazil | -0.6 |
Source: RBC GAM, Bloomberg as of June 30, 2024. For illustrative purposes only. All performance in USD. An investment cannot be made directly into an index. The above does not reflect transaction costs, investment management fees or taxes. If such costs and fees were reflected, returns would be lower. Past performance is not a guarantee of future results. Country performance represented by index Australia = MSCI Australia Index, Brazil = MSCI Brazil Index, Canada = MSCI Canada, China = MSCI China A Index, France = MSCI France Index, Germany = MSCI Germany Index, Italy = MSCI Italy Index, Japan = MSCI Japan Index, South Korea = MSCI Korea Index, New Zealand = MSCI New Zealand Index, Norway = MSCI Norway Index, Spain = MSCI Spain Index, Sweden = MSCI Sweden Index, Switzerland = MSCI Switzerland Index, Taiwan = MSCI Taiwan Index, United Kingdom = MSCI United Kingdom Index, United States = MSCI US Broad Market Index, Equal Weight Portfolio = equally weighted average of all countries represented.
Canada’s concentration risk
Investors may not realize how closely tied the performance of the Canadian market is to a limited number of companies. That’s similar to the concentration risk of the Magnificent 7 within the S&P 500.
Total weight of top 10 holdings within their respective index (%)
Source: RBC GAM, Bloomberg. Data as of June 30, 2024
Broadening your sector exposure
Relative to global equity markets, Canada is highly concentrated in three sectors: Energy, Financials and Materials. These three sectors collectively account for almost two-thirds of the value of the Canadian stock market. At the same time, Canada is significantly underweight in Information Technology and Health Care. These two sectors have been driving forces behind global earnings growth in recent years.
Source: RBC GAM, Bloomberg. As of June 30, 2024.
Investing globally can help diversify your portfolio by adding exposure to industries underrepresented in Canada. Some of these sectors are important sources of returns. Others offer defensive characteristics during cyclical downturns.
Understanding concentration risk in fixed income
Some investors focus on a small number of bonds or other fixed income investments like Guaranteed Investment Certificates (GICs). This approach can also create concentration risk.
In contrast, diversifying your fixed income holdings across issuers (i.e. government, corporate), credit quality (i.e. investment-grade, high yield) and countries can have many benefits. These include:
- reduce your portfolio’s sensitivity to interest-rate changes
- achieve a higher return potential
- add a potential income boost
Global bonds can be less volatile than Canadian bonds when hedged
While it may seem counter-intuitive, a portfolio of global bonds has historically been less volatile than a portfolio of Canadian bonds.
Source: RBC GAM, Morningstar. Three year rolling monthly volatility for the period January 2011 June 2024. Canadian government bonds: FTSE Canada All Government Bond Index, Canadian dollar-hedged global government bonds: FTSE World Government Bond Index (CAD Hedged). Standard deviation is a commonly used measure of risk and is applied to the annual rate of return of an investment to measure the investment’s volatility. Standard deviation shows how much the return on an investment is deviating from expected normal returns. A high standard deviation indicates a greater variability in investment performance.
So while Canada and the U.S. may be great places to invest – and home to many great companies – it can pay to think globally. You’ll not only avoid the pitfalls of concentration risk, you’ll also enjoy the benefits of investing in parts of the world where potential opportunities could exist beyond those at home.
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