Why You Should Diversify Out of the Magnificent 7 Stocks

As the Magnificent 7 stocks — Apple, Microsoft, Amazon, Alphabet, Nvidia, Meta Platforms, and Tesla — continue to dominate the headlines and the market, it's crucial to consider the risks and benefits of maintaining a concentrated portfolio in these tech giants. While these stocks have been the driving force behind the U.S. stock market's performance, investors should be cautious and explore diversification opportunities to mitigate risks and capitalize on broader growth prospects.



The Magnificent 7 stocks have been the market's darlings, with the group gaining 71% year-to-date in 2023, while the remaining 493 S&P 500 stocks added a mere 6%. This outperformance pushed up their contribution to the S&P 500 to nearly 30%. However, the fundamentals of these stocks aren't uniquely superior, and the breadth and depth of other growth opportunities seem historically large and attractive. There are more than 7 growth opportunities in the equity markets, with 82 US companies having forecasted year-to-year earnings growth of 25% or more. Only 3 of the Magnificent 7 companies actually passed the growth screen and they ranked #25, #72, and #74. This suggests that investors' myopic focus on the Magnificent 7 may be causing them to ignore other large cap growth stocks, and smaller stocks within the MSCI US universe comprise nearly 60% of the growth stocks passing the screen. Growth opportunities exist in sectors other than Technology, with Energy ranking higher than Technology, and Real Estate and Materials nearly identical to Tech.



Investors seem to be shunning the benefits of diversification to trade individual stocks. History suggests that isn't a prudent decision for building wealth. A concentrated portfolio of Magnificent 7 stocks, while offering high growth potential, is associated with several specific risks, including market capitalization risk, sector concentration risk, valuation risk, regulatory risk, and competition risk. To mitigate these risks, investors should consider diversifying their portfolios by allocating a portion of their assets to overlooked or underappreciated opportunities in other sectors and market capitalizations.

Some alternative investment opportunities that have been overlooked or underappreciated include:

1. Consumer Discretionary and Communications sectors: These sectors are overweighted in the growth screen, indicating that there are overlooked opportunities within them. Investors can explore companies in these sectors with strong earnings growth momentum, such as those in the consumer goods, media, and entertainment industries.
2. Energy sector: The energy sector ranks higher than technology in the growth screen, suggesting that there are underappreciated growth opportunities in this sector. Investors can consider companies involved in renewable energy, energy efficiency, or traditional energy production with strong growth prospects.
3. Real Estate and Materials sectors: These sectors are nearly identical to technology in the growth screen, indicating that there are overlooked growth opportunities within them. Investors can explore companies in these sectors that are involved in real estate development, infrastructure, or materials production with strong earnings growth potential.
4. Small and mid-cap stocks: Smaller stocks within the MSCI US universe comprise nearly 60% of the growth stocks passing the screen. These stocks seem to be more fertile ground for growth than the mega caps. Investors can consider small and mid-cap companies with strong earnings growth momentum and attractive valuations.
5. International stocks: The materials provided focus on US stocks, but there are likely overlooked growth opportunities in international markets as well. Investors can explore companies in emerging markets or developed international markets with strong earnings growth potential and attractive valuations.

To complement a portfolio that includes the Magnificent 7 stocks, investors can allocate a portion of their assets to these overlooked or underappreciated opportunities. This will help diversify the portfolio, reduce risk, and potentially enhance overall performance. By doing so, investors can take advantage of the broad and ignored group of stocks and sectors that offer attractive growth prospects.

In conclusion, while the Magnificent 7 stocks have been the market's darlings, investors should be cautious and consider diversifying their portfolios to mitigate risks and capitalize on broader growth prospects. By exploring overlooked or underappreciated opportunities in other sectors and market capitalizations, investors can create a more diversified portfolio that offers better risk-adjusted returns and the potential for enhanced overall performance.