Diversification is often described as the only free lunch in investing. The idea is simple. If you spread your investments across different stocks, the risks tend to even out over time. It’s a principle so widely accepted that it is rarely questioned.

But diversification depends not just on how many stocks you hold, but on how those stocks behave. When a few names begin to dominate outcomes, what appears diversified can, in practice, become something else entirely.

According to a study by Bastiaan van der Linden of the University of Amsterdam titled “Market Concentration and Its Effect on Diversification,” when market concentration increases, the diversification benefit of an index declines, with a growing share of returns driven by fewer companies.

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If we apply this framework to the local market, the picture tells a different story. The Philippine Stock Exchange index (PSEi) has so far declined by only 2.4 percent from the beginning of the year to date. On the surface, it suggests that the market is holding up reasonably well.

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But if we take a closer look, heavyweights tied to domestic growth and interest rates are under pressure. Ayala Land (ALI) fell nearly 30 percent. Bank of the Philippine Islands (BPI) dropped about 21 percent, while BDO Unibank (BDO) declined nearly 14 percent. SM Prime (SMPH) lost around 15 percent, and SM Investments (SM) fell over 11 percent.

These are not minor names. Together, they represent about one-third of the index and are closely linked to overall economic activity.

But on the other side was a smaller group of companies that moved in the opposite direction. ICTSI surged by about 27 percent. Meralco (MER) gained over 15 percent. Consumer names such as Monde Nissin (MONDE) and Puregold (PGOLD) rose by 17 percent and 13 percent, respectively. JG Summit (JGS) added about 14 percent.

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These gains were not only large but concentrated enough to offset much of the decline from property and banking stocks. The result is a modest 2.4-percent drop, despite underlying weakness.

From a portfolio standpoint, this may look like diversification at work. Gains in some stocks offset losses in others. But structurally, this more closely resembles a barbell strategy, where performance is driven by two extremes rather than broad participation. What appears to be balance is, in reality, concentration on both sides.

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A simple way to see this is to look at ICTSI. If this stock had been flat over the period, the PSEi would have declined by about 5 percent to 6 percent, instead of just 2.4 percent.

There is also a behavioral element behind this pattern. In uncertain markets, investors tend to favor large, familiar names. In this case, stocks such as ICTSI and Meralco became perceived safe havens, while property and banking faced pressure from higher interest rates and slower credit growth.

The result is a market that appears stable, even as underlying conditions diverge. But this stability is fragile. It depends on a small number of stocks. When too much capital is concentrated in the same names, the risk is not just that they fall, but that they fall together.

Research supports this. In a study by Pozzi, Di Matteo, and Aste of King’s College London titled “Exponential Smoothing Weighted Correlations,” they find that correlations among stocks tend to rise during periods of stress. When that happens, assets that once offset each other begin to move in the same direction. When that occurs, the barbell breaks.

Another implication is that the index may not reflect the broader opportunity set. When returns are driven by a few names, the index becomes a weighted outcome rather than an average experience. Stocks with smaller weights can move meaningfully without affecting the index.

For instance, stocks like China Banking (CHIB) and Aboitiz Equity Ventures (AEV) gained about 5 percent and 1 percent, respectively, while others such as Converge (CNVRG) and DigiPlus (PLUS) declined by around 17 percent and 16 percent. Yet their movements had limited impact on the overall index.

When capital is concentrated in a narrow group of large-cap stocks, other stocks in the market tend to be overlooked. Opportunities may exist in names that are less represented in the index, not because they are immune to macro risks, but because they are less crowded.

Viewed from a portfolio standpoint, this structure carries its own risks. The principle of diversification has not changed, but the way it is expressed in the index has. When a large portion of performance depends on a few dominant names, the market becomes more sensitive to how those names behave.

For example, if the recent winners were to correct by 50 percent, even as the weaker group such as ALI and SMPH recovers by 30 percent, the index could still fall by around 6 percent and move closer to the 5,500 level.

This is not diversification at work. It is balance. And when that balance shifts, the downside can be more pronounced than expected. INQ

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Henry Ong is a Registered Financial Planner of RFP Philippines. To learn more about investment planning, attend the 116th batch of RFP Program this May. To register, e-mail at [email protected]

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Why the PSEi may be weaker than it looks

Why the PSEi may be weaker than it looks

Why the PSEi may be weaker than it looks

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