Tech Sector Underperformance and Concentration Risk

Investor concerns over the recent underperformance of technology stocks have raised questions about the broader stock market. While strong returns among artificial intelligence stocks have supported portfolios over the past few years, they have also raised questions about the sustainability of the market rally. Concerns for tech stocks primarily include concentration risk, frothy valuations, and comparisons to prior bubbles. How can investors maintain a long-term perspective and stay balanced amid these market dynamics?

The market rally has broadened beyond tech

When it comes to tech stocks, it’s important to separate their performance from their impact on the broader market. While these companies have shown strong growth, this has also led to higher valuations, creating both opportunities and challenges for investors. History shows that leadership among both stocks and sectors tends to rotate over time as investor expectations shift, suggesting that maintaining exposure across different parts of the market is the best way to maintain portfolio balance.

The Information Technology and Consumer Discretionary sectors have lagged the broader market in the early parts of 2025. This is a reversal of the trend since late 2022 when these sectors, which include some of the largest technology companies, led the market alongside Communication Services. Instead, other sectors have contributed positively, including Financials, Materials, and Consumer Staples.

Why has this happened? The rotation has been driven by concerns over frothy valuations, higher-than-expected interest rates, and uncertainty around AI investments by large tech companies. The price-to-earnings ratio for the S&P 500 is now 22x, approaching dot-com bubble peaks, and 27.7x for the Information Technology sector. Importantly, spending on AI infrastructure continues to increase at a rapid rate, but global competition has risen as well.

The fact that other sectors have rallied is a positive sign for many investors who have hoped for a broadening of performance. While it’s still early in the year, this wider market participation suggests a healthier environment where growth is not concentrated in just a few areas. It also highlights the search by investors for more attractive valuations across different parts of the market, after two and a half years of strong returns.

Technology stocks can be attractive investments, but are naturally volatile and sensitive to the economic environment. In 2022, the Nasdaq and S&P 500 Information Technology sector each fell about 35% before rebounding quickly. Similar pullbacks occurred in 2018 and 2020 as well.

This is a recurring phenomenon, with the most famous being the dotcom bust that began in 2000. However, many other periods experienced similar trends. For instance, the 1960s technology boom centered around a group of popular technology and electronics stocks. These companies traded at high valuations before experiencing significant declines in the 1970s market downturn.

In the long run, technological breakthroughs - whether it’s semiconductors, information technology, or large language models - benefit many types of companies and sectors. The digital revolution that accelerated in the 1990s is still evolving today. For long-term investors, it's important to maintain a balanced approach that takes advantage of these broader trends, rather than attempting to time each market rotation.

Concentration risk remains a concern

Stock market sectors are also important in how they affect the broader market. The composition of major market indices has shifted over the past decade with the largest stocks in the S&P 500 now dominated by technology-related companies, sometimes known as the Magnificent 7: Apple, Nvidia, Microsoft, Amazon, Alphabet, Meta, and Tesla.

The fact that a small group of stocks has an outsized impact on the overall stock market may feel unsustainable to many investors. This is a form of "concentration risk," or the potential vulnerability from too much exposure to a single sector, asset class, or small group of investments. Many investors may unintentionally find themselves with increased exposure to certain sectors as dominant stocks in major indices grow larger.

Perhaps the simplest way to visualize this is to compare the standard S&P 500 index, which places a weight on each stock based on size, to one which gives an equal weight to each stock. The former provides a more accurate sense of the composition of the stock market, i.e., where the dollars are. Using equal weightings helps investors to benefit from a broader base of companies and their performance, regardless of their size.

Just as diversification helps protect against downside risk, concentration can amplify both gains and losses. In this environment, regular monitoring and rebalancing of portfolios may be needed to maintain desired risk levels. This makes it crucial for investors to regularly review their portfolio, ideally with a trusted advisor who understands your broader financial goals.

In the long run, many sectors contribute to portfolio returns

While a concentrated set of tech stocks has driven markets in recent years, it's important to know that this has not always been the case. History shows that over longer periods, many stocks have contributed to the success of the S&P 500, as shown in the accompanying chart.

In fact, it's also not the case that large companies always dominate stock market returns. For much of the history of the stock market, the largest companies, known as "blue chips," were often seen as the most boring, perhaps serving as a source of stable dividends.

So, while there continues to be investor enthusiasm for artificial intelligence stocks, investors should maintain a broader view on market opportunities. If AI trends are as impactful as many hope, the economic effects could be more extensive and longer lasting than previous technological revolutions, a fact that benefits balanced investors.

The bottom line? Despite concerns about the recent weakness in large tech stocks, long-term investors should remain disciplined to take advantage of all parts of the market.