Jun

15

Lots going around about how NVDA dominates; and MSFT, NVDA and AAPL now account for about 20% of the S&P 500. I was curious to see what happened in a toy index and so did an experiment (using R):

1. Create an index of 500 stocks, each with a starting value of $100.

2. Each year, for 40 years, each stock's value is multiplied by 1 + a value randomly drawn from a normal distribution with mean 8% and sd 15%, roughly what you might see with the S&P 500.

3. The starting value of the index was $50,000. The final value after 40 years was $1,152,446.

4. The final summed value of the largest 10 out of 500 stocks was $142,320, or 12.35% of the 500-stock index.

I was curious to see if megacaps would emerge from a simple toy model. I ran it only once, and they did. For me, this is a comment on the perennial alarm stories about "Only X% of stocks account for Y% of the market!" Even with a simple model, you wind up with something like that.

Adam Grimes agrees:

Can confirm. Have done variations of this test with more sophisticated rules, distribution assumptions, index rebalancing, etc. Get similar results.

Peter Ringel responds:

so we can take this ~12% of the index as a base value, that develops naturally or by chance? Then a clustering of being 20% of a total index (only greater by 8%) does not look so outrageous.

William Huggins is more concerned:

keep in mind it's 10 companies making up 12% (~1.2% each) vs 3 companies making up 20% (8.3% each) - in that sense, the concentration DOES look pretty high. am reminded of when NT was 1/5 of the entire CDN index in 99/00.

Peter Ringel replies:

You are right, I failed to catch this difference of only 3 stocks. In general, I am not so much surprised about the concentration. Money always clusters. Always clusters into the perceived winners of the day. Should they blow up, money flows into the next winner. To me, the base for this is herd mentality.

Adam Grimes comments:

It's Pareto principle at work imo. I'm not making any claims about exact numbers or percents, but as you use more realistic distribution assumptions (e.g., mixture of normals) the clustering becomes more severe. There's nothing in the real data that is a radical departure from what you can tease out of some random walk examples. Winners keep on winning. Wealth concentrates. (As Peter correctly points out.)

Asindu Drileba offers:

Maybe you try replacing the normal distribution of multiples with a distribution of multiples constructed with those historically present in the S&P 500? It may reflect the extreme dominance in the market today.

To me, the base for this is herd mentality.

It is also referred to as preferential attachment:

A preferential attachment process is any of a class of processes in which some quantity, typically some form of wealth or credit, is distributed among a number of individuals or objects according to how much they already have, so that those who are already wealthy receive more than those who are not. "Preferential attachment" is only the most recent of many names that have been given to such processes. They are also referred to under the names Yule process, cumulative advantage, the rich get richer, and the Matthew effect. They are also related to Gibrat's law. The principal reason for scientific interest in preferential attachment is that it can, under suitable circumstances, generate power law distributions.

Zubin Al Genubi writes:

Compounding of winners is also at work and returns will geometrically outdistance other stocks. No magic, just martini glass math.

Anna Korenina asks:

So what are the practical implications of this? Buy or sell them? Anybody in the list still owns nvda here? If you don’t sell it now, when?

Zubin Al Genubi replies:

Agree about indexing. Hold the winners, like Buffet, Amazon, Microsoft, NVDIA. Or hold the index. Compounding takes time. Holding avoids cap gains tax which really drags compounding. (per Rocky) Do I? No, but should. It also works on geometric returns. Avoid big losses.

Humbert H. wonders:

But what about the Nifty Fifty?


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