Global markets are currently experiencing a period of heightened uncertainty and volatility. From geopolitical instability, anti-trade sentiment to an artificial intelligence (AI) revolution. Investors around the world are being pulled in multiple directions. Decisions made in Washington have rippled outward and led to an increase in global market volatility. In this type of environment, the importance of a disciplined investment philosophy becomes increasingly important.

Concentration and hidden risks in today’s markets

Today’s global equity market has become concentrated in a small group of high-growth mega-cap stocks. While recent performance from these mega-cap stocks has been strong, history has shown that overconcentration brings elevated risk and volatility when sentiment shifts.

Today’s market draws similarities to the exuberance felt during the Tech Bubble at the turn of the century, where valuations reached record highs. Much like that era, investors are enamoured with a new innovation. Then it was the internet, which investors believed would revolutionize how people work, communicate, and socialize. That narrative turned out to be completely true, except it underestimated the time it would take and incorrectly selected who would be the winners in monetizing the information superhighway. The 10 most valuable tech stocks in 2000 underperformed the S&P 500 for the next 15 years.

Like the internet, investors believe AI will transform the world, and like its dot-com predecessor, that narrative may largely turn out to be true. But as with all technological innovation, including the internet, the pace of adoption may be slower than predicted.

Similarly, picking the winners is difficult as the leaders of today will face fierce competition and some will lose their edge. Like the market of 2000, today’s AI darlings already have lofty expectations built into their stock prices. The chart below shows where the S&P 500 (U.S. stock market) stock valuations are relative to history and the all-time highs of the internet bubble.

If their fundamentals fail to keep up with these projections, the broader story, similar to 2000, may begin to crumble and even collapse. Sharp market downturns, like the experience of the S&P 500 in the early 2000’s (-49.2%), can cause irreputable harm to retirement savings. Some investors may be surprised to learn that the exceptional U.S. equity market of today, with the internet recession and the credit crisis in 2008, had a total return of near zero over the decade ending in 2009.

Although today’s market valuations are not quite as high as in 2000, market risk may be even more elevated as the level of concentration in single stocks is much higher than the tech bubble and higher than at any time since the early 70s.

One example of how these risks can be expected to play out was expressed in an October 2024 research report: Updating our long-term return forecast for US equities to incorporate the current high level of market concentration. In this report, Goldman Sachs estimated the annualized nominal total return of the S&P 500 during the next 10 years will be 3%. This compares to the S&P 500 past decade’s 13% annualized total return. Why are future returns expected to be so low? According to Goldman Sachs, current high stock valuations combined with high levels of market concentration are the reason.

“Our historical analyses show that it is extremely difficult for any firm to maintain high levels of sales growth and profit margins over sustained periods of time. The same issue plagues a highly concentrated index. Furthermore, the risk embedded in high concentration markets is not always reflected in valuation.”

The impact of portfolio drawdowns on retirement savers

The CSS Pension Plan serves a diverse membership; retirees, those nearing retirement, and younger members just beginning their careers. When determining our investment strategy, it is crucial to consider the differing objectives of the members that make up the plan.

The weak returns forecasted by Goldman Sachs and others could be the result of a drawdown in stock prices, similar to what has occurred in previous market bubbles. The graph below highlights the severity and frequency of drawdowns in the U.S. equity market, beginning in 1926 until 2022. Drawdowns are a natural part of the market cycle, though their timing and magnitude can vary significantly. Understanding this historical context is essential for investors, as it underscores the importance of managing risk.

Stocks and Bonds underwater

Another example, outside of the U.S., is the crash of the Japanese stock market. The Nikkei 225 index (Japan) reached its all-time high in 1989. As shown in the graph below, it took the Nikkei 34 years to reach that high again. It is important to note, it is not only the magnitude of the drawdown that impacts investors, but the amount of time to recovery.

Drawdowns and volatility can have profound implications for investors of all ages. For older investors nearing or in retirement, a significant market decline can permanently impair their ability to withdraw income without depleting their principal. Negative returns in the first years of retirement can significantly reduce funds available in retirement.

The example below contrasts investors A, B and C. The only difference between investor A and C is the timing of negative returns, while investor B experiences steady returns of 5% through retirement. Although investor A and C both begin with the same initial investment and face the same returns, the timing of those returns results in very different outcomes, with investor C running out of funds after 24 years.

*Includes initial investment of $1,000,000 and annual income withdrawal of $60,000.

For younger investors, experiencing a major drawdown early in their investing journey can significantly disrupt long-term wealth accumulation, not only by reducing the capital available for compounding, but perhaps more importantly, by shaking confidence and potentially prompting emotional decisions, such as exiting the market at the worst possible time. The research results from Dalbar below evidence how all investors, not just younger investors, can be prone to emotional decisions (behavioral biases) which harm their long-term wealth accumulations:

How does CSS invest to mitigate these risks for members

Valuations/Quality/Low volatility- To mitigate the extent of drawdowns in our portfolio, we select investment managers that focus on holding stocks with reasonable valuations, high quality characteristics, and lower volatility or risk through the fundamental and quantitative analysis of company stocks. Stocks which demonstrate these characteristics have historically not only outperformed the broad market in downturns and/or the recovery period following, but have produced higher returns than the market over the long term as well.

Value in Recessions and Recoveries | Research Affiliates

Diversification across asset classes, investment styles, and geographies is a foundational principle of sound portfolio management. Diversifying investments across asset classes such as equities, bonds, and alternatives, across capitalizations (small-cap, mid-cap, and large-cap stocks), and across geographies and regions (Canada, U.S., international, and emerging markets) helps manage risk, which is key to preserving capital, and generating sustainable attractive long-term returns. At times, it may seem less effective, because it does not capture the gains of the top performing markets as significantly as a concentrated approach, but more importantly, it can protect against the downside when trend changes.

Final thoughts

Members have expressed frustration that our portfolio has not been keeping up with its market benchmarks. The fear is that they have permanently missed out on potential returns. The underperformance has largely been related the portfolio’s philosophy to mitigate risks associated with drawdowns when market risks are heightened. Our portfolio is underweight the 10 largest stocks in the U.S. equity market, which have high valuations, and in some cases less quality and more risk, have outperformed global stocks by significant margins. These stocks, largely in the tech sector, are seen as the future winners of the AI race and represented about 37% of the S&P 500 index at the end of 2024. Our preferences for portfolio diversification over concentrated stock benchmarks further impacted our returns relative to these benchmarks.

We concede, in the short term these high stock market valuations and market concentration levels provide no certainty as to near-term deep negative returns we fear. Furthermore, despite the similarities between the AI market and the dot-com bubble, we do not know how the future will unfold and on what timeline.

Despite this lack of certainty, the similarities between the current market and the dot-com bubble and other market bubbles does raise concerns. We do know from history that the combination of investor exuberance, high valuations, and high market concentration pose risks to retirement savers. Risks that can severely harm retirement accumulations and retirement income levels.

We believe the key to navigating risky and volatile markets like this is to have a sound investment philosophy.

Our philosophy is grounded in ensuring our members achieve financial security in retirement.

We believe the best path to achieving that goal is to protect members from the worst potential outcomes as opposed to capturing all the potential gains in risky markets, which history has taught us are often followed by painful corrections or recessions.

Additional information:

If you would like to learn more, please see one of our previous articles regarding diversification and our asset allocation process: The art and science of diversification.