Equity Diversification in an Era of Concentration

Key takeaways

The broad global equity indexes have become more concentrated due to an increased weight of the Information Technology and Communication Services sectors and the recent capital investment related to artificial intelligence (AI), which has seen an increased share of earnings growth from an overlapping group of firms.
The concentration on one dominant growth driver has increased the risks for investors. A handful of technology companies are delivering over half the entire global market's earnings growth, which is being fueled by the massive spending of the largest of these same companies. The risk is an unexpected deceleration of AI-related capital spending, which could result in downward revisions in future earnings for broad passive indexes.
The investment principle of diversification suggests investors diversify their portfolios by investing across asset classes, within asset classes, and across investment styles. Diversification can help smooth returns and lessen the impact of a poor outcome from a single holding. The issue for the equity asset class is that the broad passive global equity indexes have become less diversified due to the increased concentration on one growth driver.
By looking beyond the broad passive large capitalization (cap) indexes, investors can improve equity diversification by adding any of the following to portfolios; international equities, stocks in sectors and industries with low correlation to the AI trade, small cap equities, and investments that are benchmarked to indices using alternatives to market capitalization weighting schemes, such as equal-weight or fundamental factors such as Value and Yield.

What do we mean by market concentration and why is it relevant?

Market concentration has become a defining characteristic of today's global equity market. This concentration has shifted passive equity portfolio exposures toward technology and away from everything else, reshaping the risk-versus-return assessment for investors. More recently, it has also become intertwined with the AI investment wave producing extraordinary earnings growth for a narrow set of industries and companies.

At a global level, the Information Technology (Tech) sector's market cap as a percentage of the MSCI All Country World Index (ACWI) has doubled over the past 10 years, from 15% at the start of 2016 to 30% today. However, over the same period, tech earnings per share (EPS) has grown at an even faster pace relative to the rest of the global market, supporting the arguments that tech's rise has been fundamentally driven and that concentration itself isn't a problem. Indeed, with the pace of ongoing technological innovation, the era of dominant tech firms may continue.

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While we acknowledge the argument that market cap concentration is not necessarily a risk in isolation, we've also seen global earnings growth become dominated by a narrow set of tech-related industries and companies—thanks to the massive investment pouring into AI. For 2026, tech is expected to produce 47.6% of global earnings growth, based on the MSCI ACWI.

Rather, it's the combination of market cap and earnings concentration that presents a challenge for investors: we now have equity markets overwhelmingly comprised of tech companies, with a handful delivering over half the entire global market's earnings growth, which is being fueled by the massive spending by the largest of these tech companies.

The circularity of these conditions—and the large reliance on the AI theme—is where the risks add up. Fortunately, diversification strategies become more accessible when markets are highly concentrated and equity investors can pursue any number of ways to increase portfolio breadth.

How investors can increase diversification today

It's important to note that diversification is not simply about owning more stocks or funds. Rather, it's about having exposure to differentiated sources of potential return. From a global equity perspective, this can come from any combination of geographic, sector, or factor exposure. We see opportunities in many of these areas today.

Diversification opportunity No. 1: Geographic

The period from the early 1990s through 2010 saw the steady expansion of globalization, a synchronization of global economic cycles, low inflation and declining interest rates, and increasing correlations across equity markets.

The Global Financial Crisis and the subsequent global policy responses helped herald a change to this world order. Fast forward to today and we've just experienced a 15-year run of extraordinary U.S. equity outperformance during which time globalization stalled, geopolitical tensions rose, regional economic cycles became desynchronized, inflation and rates moved higher, and country equity correlations fell.

While today's leading U.S. companies, particularly in the Technology sector, are forecast to continue delivering EPS growth above broader market levels, based on consensus estimates, and we've seen steady earnings growth in most major regions and sectors, reflective of ongoing cyclical economic expansion.

Moreover, with the rise in geopolitical tensions, many countries are increasing efforts to stimulate domestic growth and insulate their economies from external shocks. Policy makers in Europe, Japan, and emerging markets are reassessing domestic security, which includes military defense, energy security, food security, and—increasingly—industrial security.

This is not to say we expect a reversal in U.S. versus global market performance any time soon. The U.S. continues to enjoy a number of advantages that could sustain faster relative growth. Indeed, we continue to suggest that investors retain their strategic allocation to the U.S. equity market.

But it's important to acknowledge how conditions have changed over the last 15-plus years of U.S. outperformance, including the macroeconomic and geopolitical environment as well as market conditions including overall capitalization and valuations, investor positioning, consensus expectations, etc. These factors all lead us to the view that equity investors may be well served to consider more actively balancing geographic exposure.

Adding or increasing allocations to major regional markets likely widens exposure to different return drivers—from broad economic drivers to different sector exposures as well.

The MSCI World excluding the USA Index covers all major developed markets and has a significantly different sector composition than U.S. equity markets. For example, the Tech sector, which is nearly 37% of the S&P 500, is just 10% in the MSCI World ex USA Index. On the other side, global developed markets have much higher exposures to the Financials, Industrials, Energy, and Materials sectors versus the U.S. market.

Diversification opportunity No. 2: Sector and factor diversification

It's absolutely true that if one had held a highly concentrated portfolio of large cap U.S. technology stocks, they would have outperformed significantly over that last decade. The Magnificent 7 didn't get that moniker because they underperformed. Said differently, being underweight tech and the fastest-growing stocks over the last decade would have likely resulted in underperformance.

However, starting points matter. Today's circumstances are quite different than they were just 10 years ago. And it's not just about the large market weight of tech, but also the added concentration of rapid investment from mega-cap tech firms fueling dramatic earnings of other tech companies in the AI supply chain. Today, tech valuations are high on both an absolute and relative basis with markets seemingly discounting sustained strong growth and profitability with very high earnings expectations throughout next year.

All of this raises the bar for tech to continue to surprise to the upside. Moreover, should downside scenarios materialize—or even become more likely—the sheer weight of the Technology sector in portfolios could pose a challenge for risk management and return requirements.

The following chart shows S&P 500 sector correlations to the S&P 500 Tech sector. The chart shows the range of each sector's correlation to Tech over the last 10 years with the box plot representing interquartile range (the range of 25th to 75th percentile) and the whisker for the interdecile range (the range of 10th to 90th percentile). The hollow dots on the chart represent correlations to the Tech sector over the last 12 months. Note that most of these dots are well below the historical range. This represents a more recent decoupling between Tech and the rest of the market and reflects the improved diversification opportunity through sectors.

Increasing exposure to sectors with low correlation to technology themes tends to provide diversification, but that does not guarantee outperformance, nor prevent losses. Investors are faced with the choice to accept the status quo of (1) holding the highly concentrated market portfolio with returns dominated by a handful of stocks and one major theme; or (2) rebalancing allocations away from the concentrated areas, which could risk underperforming the broader market should technology and the AI-related stocks continue to outperform. The choice depends on one's time horizon, sensitivity to relative market performance, risk appetite, and achieving goal objectives.

Another way to broaden portfolio exposures is via style factor, including increasing exposure to small- and mid-cap stocks. The S&P SmallCap 600 Index has a more balanced sector exposure relative to the S&P 500. Factor indices like Value and Dividend Yield are other examples that have low correlations to Tech.

Schwab clients can use the Schwab ETF Select List to screen for sector-focus funds.

Diversification opportunity No. 3: Alternative index construction

While market-cap weighting methodologies are the most prominent, there are a range of other approaches behind index construction. One simple example that increases diversification is the S&P 500 Equal Weight Index, which allocates the same weight (0.20%) to each of the S&P 500 constituents and rebalances these exposures quarterly. This doesn't mean all sectors have the same weight, just that all individual companies do. Sector weights are largely driven by the number of companies in each sector not the number of stocks—so if one sector has more constituents, it will have a higher sector weight.

As the chart below shows, the S&P 500 Equal Weight Index has a more balanced allocation across sectors versus the market capitalization-weighted S&P 500 Index, with the biggest exposure difference across the largest companies in the index. The top 10 largest companies make up 38% of the market capitalization weighted S&P 500 Index, but those same companies have just a 2% weight in the S&P 500 Equal Weight Index.

Another option investors can explore is fundamental indexing, which builds and weights portfolios by company revenue growth, profitability, cash flow generation, yield, or other company fundamentals, and can offer exposure to targeted company characteristics rather than just exposure to the companies with the largest market value.

The RAFI Fundamental U.S. Index, a fundamentally weighted index strategy of large-cap U.S. stocks, is often used as a benchmark for these strategies. This index has actually managed to outperform the S&P 500 over the last five years despite significant compositional differences.

The following table shows the difference in top 10 holdings both by weight and by sector exposure between the RAFI High Liquidity U.S. Large Cap Index and the S&P 500 Index.

Diversification opportunity No. 4: Single stock

For investors interested in individual stocks, the Schwab Stock Screener can help find stocks that may be useful for adding diversification. To access the Screener, log on to Schwab.com. From the menu at the top select Research and then Stocks. Next, select the Stock Screener.

We analyzed the correlation of sectors and industries in the Russell 3000 Index to a basket of AI-related stocks. We have ranked each sector of the index by correlation with this basket over the past two years. The Utilities, Consumer Staples, Energy, Health Care, and Real Estate Sectors had the lowest correlations.

Schwab clients can access the Schwab Stock Screener to screen for large capitalization stocks. To run similar analysis, set your screening parameters to the following:

Basic > Sectors and Industries > Consumer Staples
Basic > Market Capitalization > $50B or more

In the table below, we list the five largest companies by market capitalization in each of the Consumer Staples, Energy, Health Care, Real Estate, and Utilities sectors, which are the sectors with the lowest correlation to Technology.

Investment implications

The underlying composition of equity indices is changing all the time. This can be a benefit to investors holding investments that track index funds as index composition typically shifts toward those companies and industries showing strong fundamental growth. But it can also be a risk if broad indices become dominated by any one particular source of return. A challenge for investors today is that the Technology sector now accounts for an unusually large share of global index composition and is expected to deliver more than half the entire global equity market’s earnings growth for 2026, according to consensus estimates and our calculations.

From our perspective, the combination of market cap and earnings concentration—and the circularity of these conditions (including the large reliance on the AI theme)—is where the risks add up.

These considerations do not mean we foresee an imminent end to the AI investment cycle or the powerful earnings growth it's generating. Rather, we acknowledge that there are any number of possible outcomes of this current technological innovation story. However, high Tech sector valuations combined with elevated earnings expectations imply that markets are discounting a quite optimistic outcome, based on our analysis. From this perspective, we see the risk outlook having shifted to the downside; that is, there are now greater downside risks than upside ones.

While we can’t predict how the AI innovation cycle will play out, we believe more active diversification can potentially improve risk-adjusted returns across a range of potential scenarios. This isn't a call to abandon the Tech sector or those companies most benefiting from the related investment cycle, but we do believe more actively diversifying portfolios is warranted. Of course, diversification alone does not ensure a profit nor protect against losses.

This material is intended for general informational and educational purposes only. This should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned are not suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decisions.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results.

Investing involves risk, including loss of principal and for some products and strategies, loss of more than your initial investment.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets.

Investing in emerging markets may accentuate this risk.

For illustrative purposes only. All corporate names and market data shown are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.

Diversification, asset allocation and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets.

Rebalancing may cause investors to incur transaction costs and, when a non-retirement account is rebalanced, taxable events may be created that may affect your tax liability.

Small-cap investments are subject to greater volatility than those in other asset categories.

Schwab does not recommend the use of technical analysis as a sole means of investment research.

Sectors are determined using the Global Industry Classification Standard (GICS®). Global Industry Classification Standard (GICS®) was developed by and is the exclusive property of MSCI Inc. (MSCI) and Standard & Poor's (S&P).

Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. For more information on indexes, please see schwab.com/indexdefinitions.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Source: Bloomberg Index Services Limited. BLOOMBERG^® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively "Bloomberg"). Bloomberg or Bloomberg's licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg's licensors approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The MSCI All Country World Technology Index is a market-cap-weighted equity index designed to track the performance of large- and mid-cap companies in the Information Technology (IT) sector across all developed and emerging markets worldwide.

The MSCI ACWI ex Technology Index is a free float adjusted, market capitalization weighted index that measures the performance of large and mid cap equities across Developed Markets (DM) and Emerging Markets (EM) countries, excluding companies classified in the Information Technology (IT) sector under the Global Industry Classification Standard (GICS®).

The MSCI World ex USA Index measures the performance of large and mid-cap companies across developed markets, excluding the United States.

The S&P 500 Equal Weight Index (EWI) is an alternative version of the widely used S&P 500 index. The S&P 500 Equal Weight Index assigns the same weight to each of the 500 companies in the S&P 500, giving smaller companies equal influence as the largest ones.

The RAFI Fundamental U.S. Index is a non-market-cap-weighted index that selects and weights U.S. companies based on fundamental measures of size, such as book value, cash flow, sales, and dividends, rather than stock price.

The RAFI Fundamental High Liquidity US Large Cap Index weights companies based on fundamental measures of size rather than market capitalization, applying liquidity screens and systematic contrarian rebalancing to capture potential excess returns.

MSCI China represents a market-cap-weighted index of investable Chinese equities, tracking the performance of major Chinese companies accessible to international investors.

The MSCI Brazil Index is a benchmark that measures the performance of large and mid-cap Brazilian stocks, covering about 85% of the country’s equity market.

The MSCI Canada Index tracks the performance of large and mid-cap Canadian equities, covering approximately 85% of the free float-adjusted market capitalization in Canada.

The MSCI Germany Index is designed to measure the performance of the large and mid-cap segments of the German market.

The MSCI India Index is a benchmark that tracks the performance of large- and mid-cap Indian stocks, serving as a key reference for global investors in the Indian equity market.

The MSCI Japan Index is designed to measure the performance of the large and mid-cap segments of the Japanese market.

The MSCI Korea Index is a global equity benchmark that measures the performance of the large- and mid-cap segments of the South Korean stock market from the perspective of international investors.

The MSCI United Kingdom Index is designed to measure the performance of the large and mid-cap segments of the UK market.

The MSCI Switzerland Index is designed to measure the performance of the large and mid-cap segments of the Swiss market.

The MSCI Taiwan Index is designed to measure the performance of the large and mid-cap segments of the Taiwan market.

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