It’s understandable to feel anxious. But reducing equity exposure can be counterproductive because it’s nearly impossible to time market inflection points. The challenge is to find a strategy that can help you stay invested through bouts of volatility. In our view, the solution is to identify stocks with attractive long-term upside potential as well as solid, defensive characteristics to weather today’s risks.
US Peak-to-Trough Drawdowns Have Been Steep
The digital age has given rise to technology firms that can generate profits without excessive cyclicality—a unique feature of US markets. US companies’ focus on profitability, coupled with favorable shareholder return policies, has widened the shareholder wealth gap between the US and the rest of the world.
But even large, profitable US companies can be punished if they don’t meet near-term expectations. Partially as a result, US markets have endured larger peak-to-trough drawdowns during recent crises than international markets, our research suggests. These include the COVID-19 pandemic, the global financial crisis and the tech bubble of the early 2000s.
Sharp pullbacks create risk drag, which can corrode long-term returns. They can be particularly unnerving in the post-accumulation stage of investing. Retirees living on fixed incomes feel the pain of a sell-off more acutely than wage earners who can dollar-cost average into a falling market. Stocks that lose more in downturns also have more ground to gain when the market recovers, making downdrafts particularly daunting for investors in a more volatile US market.
Does Market Concentration Add Risk?
That volatility could persist given the high degree of concentration in the US. In recent years, a disproportionate amount of US market gains has been generated from relatively few stocks. Technology mega-caps have taken center stage since artificial intelligence (AI) unleashed a wave of enthusiasm about future earnings growth potential.
Consider, for example, the heaviest hitters of the S&P 500. The 10 largest stocks, which comprised just 15% of market capitalization a decade ago, now account for nearly 40% of the index (Display). That means a mere 2% of S&P 500 constituents have the power to move the broader market up or down.
