Palumbo Pulse July 1st, 2024: Set it, But Don’t Forget It

Most 401ks (and 403bs) are structured to funnel participants into indexed funds. The goal is to push them into a ‘no think’, diversified portfolio, often designed to alter the mix of stocks and bonds automatically as they age. While interest rates came crashing down, the strategy looked like pure genius, but with the bond bull market now over and rapidly rising federal debt, the diversification benefit from bonds has become less predictable, making retirement plan investing more complicated.

Meanwhile, the stock market has become extremely concentrated. While that can do wonders for your portfolio when the concentration works in your favor, it can get downright ugly when it works against you. From a portfolio standpoint, what that means is that the diversification strategy that has benefitted retirement plans for many years is becoming less and less diversified.

The chart below, which we found on advisorpedia.com, shows that for a period of roughly 20 years, from 1999 through 2021, stocks and bonds were negatively correlated. What that means is that as stocks prices moved up or down, bonds tended to move in the opposite direction. This diversification smooths out portfolio returns, making portfolio values over time vary less than if the portfolio was invested in only stocks or only bonds.

Since 2022, stocks and bonds have become correlated once again. The mantra has been rates down-stocks up for a while now. The massive stock rally we have seen since late 2023 began when the Fed implied that rates would soon come down. Of course, declining rates also send bonds prices up, too. Correlations vary over time, but for the time being we appear to have moved into a new correlated regime, which means that the diversification benefit we’ve become accustomed to in our 401ks is not working as well as it had been for the previous 20 years and that presents a new challenge for retirement plan participants. The ‘set it and forget it’ approach may not work as well as it used to work.

Concentration

This portfolio challenge is being compounded by broad stock indexes that have become very concentrated. If you invest a dollar into an S&P 500 fund, 28 cents of that dollar are invested in only 5 companies, which is the largest percentage on record by a wide margin (see chart below). Ten years ago, that same dollar allocated only 11 cents into the top 5 companies. The structure of the S&P index is more concentrated, meaning less diversified.

The NASDAQ index is even more extreme. If you allocate $1 into a Nasdaq 100 ETF, 36 cents are invested in the top 5 stocks. This would be even higher except the index changed its methodology last year to limit the weights of the largest companies! Even the index providers are concerned about the concentration of supposedly broad indexes!

We witnessed an example of how concentration can hurt in 2022, when the tech sector had a nasty correction, and the S&P 500 was down some 18%. Since then, the concentration of the top 5 has only grown larger. A repeat of 2002 would likely have worse results.

Our point is that this bull market run has spoiled us by making things look far too easy. The decline of diversification in these ‘diversified’ strategies, ultimately makes them subject to more risk. The ‘set it and forget it’ retirement plan strategy has worked for a long time, but that run could be running out of steam.

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All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.

?The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

?Past performance is no guarantee of future returns.