Risk and Reward…
August 2, 2025
Near the end of the last millennium (that's only 25 years ago), stock equity holdings overcame real estate as the largest asset for households. The market’s climb since then has only increased the gap and cemented the situation. Unsurprisingly, that has resulted in increased public attention to market activity, a variety of new investment options and, yes it must be said, even gambling of a sort (e.g. zero-day options which expire on the same day they are purchased). It isn’t your grandmother’s market anymore.
In our commentaries, this space has often been filled with cautionary advice. ‘Don’t fall in love with your stocks’, ‘don’t be greedy’, ‘pay attention…it’s your money’, etc. What hasn’t been discussed is ‘alpha’, the holy grail of investment management. Alpha is a measure of investment performance, compared returns to a particular market benchmark, often the S&P 500. It essentially quantifies how much return an investment generates above and beyond what would be expected given its level of risk. If the S&P 500 was up 10% and your portfolio was up 12%, you have achieved 2% of excess return, or alpha, if the S&P500 was your benchmark.
The key phrase in that definition - one that is easily overlooked - is ‘given its level of risk’. If you invested a large percentage of your capital in one stock or a narrowly defined ETF, your idea might have proved correct and you would surely have created alpha, possibly exceeding any likely benchmark. Investing in that manner also would have exposed you to a much higher level of risk, a much greater chance of significant losses if the market action did not align with your investment view.
In the final analysis, it all comes back to risk vs. reward. As measuring risk has many factors and is not really a simple, straightforward process, most investors do not directly concern themselves with deliberately seeking, and measuring for, alpha. And the markets’ historical pattern of generally rising renders considerations of creating alpha much less meaningful for most investors. After all, an annual gain of 7%, compounded over ten years, doubles your portfolio value. That concept, compounding returns, has led to the dramatic growth of passive investing. With preset investment instructions, a steady flow of money from 401K accounts and IRA’s is directed into index fund ETF’s (e.g. SPY) and other instruments that mimic a broad based portfolio. Theoretically, the ETFs’ should provide diversification, reducing risk by avoiding concentration in the portfolio. Increasingly, however, that may no longer be the case.
The S&P500 index is a market cap weighted index, meaning that the largest companies have the greatest impact on the index. At the peak of the dot-com bubble, a famously frothy period of overvalued equities, the ten largest stocks in the S&P 500 index accounted for approximately 20% of the index’s total market capitalization. At the time, that was an unusually large percentage. And yet today, the ten largest companies in that index represent 38% of the total concentration, almost double the amount of that earlier period. Buying an index fund these days, therefore, has increased the concentration risk for investors and, frankly, increased the risk inherent in the overall market. It isn’t your father’s market anymore, either.
This isn’t a crisis, not even necessarily a major problem. After all, those companies (e.g. Microsoft, Amazon, Nvidia...) are large because they have performed well, grown quickly, remained very profitable...all of which has been reflected in the rise of the S&P500. Yet it is a situation to be cognizant of. In an elevated market like we currently have, a major reversal could occur for any number of reasons - change in the thinking around the AI opportunity, an administration policy that targets tech company profitability, raised tariffs and illegal immigrants deportations having a greater negative impact than expected, or some kind of unanticipated ‘black swan’ event arrives (e.g. another Covid-like virus, a major private credit market crisis). Portfolios could be damaged beyond expectations as a result of the unwitting, hidden concentration that currently exists. The S&P500 has risen to record levels...risk vs. reward...and the risk now is greater. Just be cognizant and stay vigilant, review your investment instructions.
Finally, on a totally different topic, I spend a lot of time in a coastal town - beach preservation and maintenance is a constant topic. Passions run deep. The link below is an excellent discussion of the issues and the difficulty of dealing with beaches and rising water levels. Most of you probably like to go to the beach…maybe it would be useful to understand a little more about what is involved in maintaining and preserving them. Read on…