September 29, 2020

Is the stock market over-exposed to the tech giants?

The five tech giants (Apple, Microsoft, Amazon, Google, Facebook) account for 20% of the total US stock market capitalization. This fact leads some financial advisors to say that investors holding the market portfolio are poorly diversified, because they are over-exposed to the tech sector and a handful of tech companies (an example of this view here).

Is this concern justified?

The usual recommendation of finance theory (such as the CAPM, which students currently taking Financial Economics will soon learn about) is that investors should buy the market portfolio. Does this logic break down when one sector represents a very large share of the overall market?

The answer is no. While it is true that the market portfolio has a large exposure to the tech sector and the tech giants, this happens because tech represents a growing share of economic activity. Therefore, a portfolio representative of the real economy should have a large exposure to the tech sector.

Moreover, stock prices are forward looking (as we study in the Financial Markets course). It means that the market capitalization of the tech giants is determined not just by their current importance in the economy, but also by — and in fact, mostly by — expectations about their future importance in the economy. This explains why tech accounts 20% of the stock market even though it does not yet account for 20% of GDP.

To be sure, saying that a well-diversified portfolio should include a large amount of a handful of large stocks, does not mean it is a good thing that the economy is dominated by a handful of very large companies. Many people actually think the opposite and I will not take a side in this short blog post! The point is that, taking as given the composition of the market, the advice that one should hold the market portfolio still holds even when the market includes very large companies.

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