Editor’s Note: Robert Rapier points out below that the ten biggest stocks now make up roughly 40% of the S&P 500 — and the index as a whole pays just 1.07%. Only fifty-two of its five hundred companies still yield 4% or better. Our colleague Nathan Slaughter counted them, and published what each of seven yielded on the day High-Yield Investing bought it. See the seven →

Diversification is one of the oldest principles in investing, and for good reason. Spreading money across different sectors, industries, and asset classes reduces the risk that one bad investment or one struggling corner of the market can do serious damage to a portfolio. But there are periods when diversification can feel less like protection and more like punishment, and the current market is a good example.

The major indexes remain near record highs, but those headline numbers increasingly obscure what is happening beneath the surface. A relatively small group of technology and artificial intelligence-related stocks has been responsible for a disproportionate share of the market’s gains, while many other sectors and smaller companies have struggled. The top 10 stocks now account for roughly 40% of the S&P 500, up sharply from where that concentration stood when the current bull market began in October 2022.

For investors with diversified portfolios, that can create a frustrating disconnect. You can look at an S&P 500 sitting near record territory, then look at your own holdings and see plenty of red. Utilities are struggling, smaller companies may be weak, and income-oriented names are under pressure from high interest rates. If you do not own large positions in the handful of companies driving the major averages higher, your experience can look very different from what the financial headlines suggest.

The Index Is Not the Whole Market

The reason is partly structural. The S&P 500 is weighted by market capitalization, which means the largest companies have the greatest influence on its performance. When those companies are also the strongest performers, the index can rise even if a large share of its constituents are going nowhere or moving lower.

That is why I often look beyond the standard S&P 500 when I want a better sense of market breadth. The equal-weighted version of the index, which gives each company roughly the same influence, has lagged the cap-weighted index significantly as leadership has narrowed. Small caps tell a similar story. The Russell 2000 has struggled even while the S&P 500 has remained near record highs, reinforcing the point that the performance of the headline index and the experience of the average stock can diverge sharply.

That distinction matters because investors often use the S&P 500 as a shorthand for “the market,” when in reality it is only one slice of the market, and one that is currently dominated by a relatively small group of very large companies. A diversified portfolio that spreads exposure across different sectors, styles, and market capitalizations is naturally going to behave differently from an index that is increasingly concentrated in a handful of winners.

Diversification Means Owning What Is Not Working

This is where diversification becomes psychologically difficult. By definition, a diversified portfolio will not be fully concentrated in whatever happens to be leading at the moment. If megacap technology stocks are dramatically outperforming, then owning utilities, financials, energy producers, health care companies, consumer stocks, REITs, and smaller businesses will almost certainly drag on relative performance.

That can tempt investors to conclude that diversification is the problem. The obvious response seems to be selling the laggards and moving more money into the stocks that are already working. Sometimes that strategy can continue to pay off for a while, but it also introduces a different kind of risk: performance chasing.

The problem with performance chasing is that investors usually recognize a trend only after it has become well established. By that point, valuations may already be stretched and expectations may be extremely high. Reducing diversification at that stage can leave a portfolio more exposed precisely when concentration risk is at its greatest.

Diversification Works Over Cycles

The purpose of diversification was never to ensure that a portfolio beats the best-performing index every quarter or every year. Its purpose is to reduce the consequences of being badly wrong about which investments will lead next.

Market leadership changes over time. Technology can dominate for years, then energy can lead. Small caps can outperform for an extended period and then disappear from favor. Utilities and dividend stocks can lag badly when interest rates rise, then become much more attractive when rates fall or investors begin looking for stability and income again.

The challenge is that those turning points are obvious only in hindsight. Nobody reliably knows when one leadership regime will end and another will begin, which is why diversification remains valuable even during periods when it feels frustrating. It is an acknowledgment that the future is uncertain and that building a portfolio around one prevailing trend can work very well until it suddenly does not.

Narrow Markets Can Create Opportunity

There is another side to narrow leadership. When investors crowd into a relatively small group of companies, other parts of the market can become increasingly attractive.

That does not mean every lagging stock is a bargain. Some companies are underperforming because their businesses are deteriorating, debt burdens are becoming more difficult to manage, or earnings expectations are falling. Higher interest rates have also created real pressure for rate-sensitive sectors and heavily indebted businesses, so weakness should never be dismissed automatically as a buying opportunity.

But broad underperformance can also create attractive entry points in fundamentally sound companies. When an entire sector falls out of favor, good businesses can get marked down along with weak ones. That is where valuation, balance-sheet strength, cash flow, and competitive position become more useful than simply asking whether a stock has kept pace with the S&P 500.

For long-term investors, those periods can be productive. The goal is not to buy whatever has fallen the most, but to identify businesses that remain healthy even though investor enthusiasm has shifted elsewhere.

Lagging Is Not the Same as Failing

There is an important difference between a portfolio that is lagging and one that is failing. A failing portfolio may contain deteriorating businesses, too much leverage, poor diversification, or investments bought at unrealistic valuations. Those are legitimate problems that need to be addressed.

A diversified portfolio that temporarily trails a concentrated index is something else entirely. If the underlying businesses remain sound and the portfolio still reflects your objectives and tolerance for risk, then underperformance against an unusually narrow benchmark may simply be the cost of diversification.

That cost can feel uncomfortable, especially when the major averages are rising and many of your own holdings are not. But diversification was never designed to make sure you always own more of yesterday’s winners. It was designed to reduce the risk that your financial future depends on correctly predicting which small group of stocks will dominate tomorrow.

In a market this narrow, that distinction is worth remembering.

Robert’s closing point, that lagging is not the same as failing, has a practical side for anyone who owns income stocks in a market like this one: when a few giants set the index’s direction, the dividend-payers are easy to ignore, and the ones still yielding 4% or better are rarer than most investors realize (fifty-two of five hundred). Our colleague Nathan Slaughter runs High-Yield Investing on exactly that scarcity: fifty-seven income positions averaging 5.8%, against an index paying 1.07%. His flagship report covers seven of them with the number almost nobody publishes, what each one yielded on the day he bought it. See the seven →