Is concentration in the stock market risky?

Terry Smith of Fundsmith claims that passive funds are setting the stage for a significant investment catastrophe

Is he correct?

Nobody would consider Shell, BP, HSBC, AstraZeneca, and British American Tobacco to have an exciting portfolio.

However, a study of all UK-listed stocks over the previous 50 years revealed that these five and the top ten wealth creators accounted for almost one-third of the actual wealth produced by UK stocks. Over that period, thousands of listings came and went. These persisted and grew, and they occasionally appear in the most well-liked stocks bought by do-it-yourself investors.

Because of this, it is worthwhile to investigate the current concerns regarding market concentration. Currently, 39% of the SandP 500 are made up of the Magnificent 7. For the first time, the share of passive fund assets in US equity funds has surpassed 50%.

BFIA's current problems. Terry Smith cautioned that the move to index funds is "laying the foundations of a major investment disaster" in his letter to shareholders in January 2026, but he acknowledged that he was unable to predict when or how it would end.

It's a persuasive argument. When a major index is dominated by seven stocks, something is off. However, three recent studies that cover US and UK stocks over 50nearly 100 years present a different picture. A very small number of businesses have always created the majority of the wealth. Whether or not your index is top-heavy is not the question. It's whether you have a better chance with the alternative.

And the evidence for that is compelling.

Which UK stocks produced the highest level of wealth?

The entire wealth was generated by just 3% of UK stocks. The Journal of Asset Management recently published a peer-reviewed study that quantifies what many investors suspect but few fully understand. Every stock listed between 1975 and 2024 on the London Stock Exchange, the Unlisted Securities Market, and AIM was examined by Jonathan Fletcher and Michael O'Connell of the University of Strathclyde. They discovered that, in actual terms, only 3.1% of those businesses produced all of the market's total net wealth creation.

No one will be surprised by the names that did the heavy lifting. AstraZeneca, Rio Tinto, GlaxoSmithKline, Shell, BP, HSBC, British American Tobacco, and Unilever are uninteresting but reliable.

Almost one-third of the total wealth generated was captured by the top ten individuals alone. While the headline stocks came and went, these stocks quietly increased in value.

Over the course of their lives, over half of all UK stocks were unable to outperform Treasury Bills. After inflation, the median stock saw a 13.9 percent lifetime real return. The market segment known for its exciting growth stories and tax-efficient wrappers, AIM, generated a negative aggregate net wealth of £2.6 billion.

This is not unique to the United Kingdom. Arizona State University's Hendrik Bessembinder, whose 2018 study initially identified the trend in the US, has updated his data through 2022. Just 4% of stocks contributed to the £55 trillion in net shareholder wealth created over the course of nearly a century of American stocks. At best, the remaining 96% matched Treasury Bills as a whole.

Two separate markets. Two separate eras. The same conclusion: the creation of equity wealth has consistently been extremely concentrated. The many are carried by a few.

Therefore, today's top-heavy indices are not a distortion when only 3% of stocks produce all of the total wealth. They are a reflection of how markets function. Additionally, if you're selecting individual stocks from a pool where the median result is a loss, you're betting that you can spot those winners in advance.

In actuality, avoiding market concentration made matters worse.

In their recent paper, The Fallacy of Concentration, Mark Kritzman of Windham Capital Management and MIT Sloan and David Turkington of State Street Associates sought to address the question of what happens if concentration is structural.

They developed a dynamic approach that decreased equity exposure during periods of historically high market concentration and increased it during periods of declining concentration. Lower returns, increased risk, and less than half the total wealth of remaining invested are the outcomes.

The investor who chose to buy and hold received a Sharpe ratio of 0.52. 0.39 was earned by the concentration-avoider. Over the entire period, both had the same average equity exposure of 67.8%. It was not courage or conviction that made the difference. It had to do with combating a market feature that turned out not to be a bug.

Big businesses aren't just big. In terms of structure, they are less unstable. According to Kritzman and Turkington, the largest decile of S&P 500 stocks had annualized volatility of 19.2%, while the smallest decile had 28.8%. Contrary to popular belief, a market dominated by big businesses tends to be calmer.

Smith is correct in saying that passive flows automatically steer capital toward the largest stocks. Cap-weighted indexing functions in this manner. However, whether the concentrated index is riskier than the concentrated stock-picking portfolio is more important than whether that mechanism exists. The evidence is unambiguous on that.

Purchase the complete book.

Stock pickers are left with an awkward question by the Fletcher and O'Connell data. Choosing individual stocks seems more like a raffle than a skill competition if the great majority of listed companies lose value over the course of their existence. Studying the tickets more thoroughly is not the logical course of action. To purchase the entire book.

Naturally, Terry Smith would not agree. His own record, however, is instructive. In 2025, Fundsmith's return was 0.8% compared to the MSCI World's 12.8%. This was Smith's fifth year in a row of poor performance.

The fund has now fallen short of its benchmark over the last five and ten years, according to Laith Khalaf, head of investment analysis at AJ Bell.

Khalaf's broader argument is also worth considering: "The low interest rate environment that complemented Smith's quality style partially flattered Fundsmith's earlier outperformance." The structural headwinds that stock pickers face are more difficult to ignore now that the tailwind has reversed. A "

That has no bearing on Smith's intelligence or methodology. It is a reflection of the odds, and reputation has no bearing on those odds.

It is important to comprehend market concentration. You should watch it. However, three studies covering two markets and nearly a century of data show that a top-heavy index is not the risk that most investors should be concerned about. This portfolio places a wager against the 3% holding all other assets.

The better odds are often hidden in plain sight for the majority of us.

Examine the London Stock Exchange FTSE further.