Expert perspective

The Magnificent Seven: A study in market cyclicality

July 09, 2024

Shares in just seven companies—Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla, known collectively as the “Magnificent Seven”—have accounted for a significant portion of the U.S. equity market’s return in recent years. Some observers express risk concerns, but a hypothetical portfolio tracking the Russell 3000 Index except for those companies would have lagged the index by approximately 2.1 percentage points, annualized, over the past 10 years.1

While investors would have been worse off if not for the Magnificent Seven, we wondered: Has it always been more important to hold the stock market’s top contributors, or have there been times when it was more important to not hold the market’s biggest detractors?2 Now unfolding is a study in market cyclicality.

Market leaders grab headlines; do laggards have more influence on market returns?

To answer this question, we replicated the constituents of the Russell 3000 Index to reflect its changing makeup over the period from January 1, 2000, through December 31, 2023. Then we split the 24 years into 12 two-year subperiods, calculated each stock’s contribution to the index return, and simulated alternative courses of history for the U.S. stock market by excluding entire groups of stocks from both ends of the contribution distribution.3

The bars in the chart that follows show the net effect in each subperiod of excluding both the top contributors and the biggest detractors from the Russell 3000 Index.

A look across all 12 two-year periods reveals an interesting pattern. In the early years of our analysis, it generally was more important to avoid the worst detractors, because they weighed on the market more than the top contributors helped it. In the latter years of our analysis—that is, the Magnificent Seven era—it has been more beneficial to hold the top contributors than to avoid the biggest detractors.

The net impact of not holding the stock market’s top contributors and detractors is a function of how large-caps perform relative to small-caps

For each of 12 two-year periods from 2000 through 2023, a bar chart shows the net gain or loss from excluding—from a hypothetical portfolio—the 10 largest contributors to and detractors from the stock market’s overall return. From 2000 through 2013, the gain from excluding the 10 biggest detractors tended to exceed the opportunity cost of excluding the 10 biggest contributors. The performance edge averaged perhaps 1%–2%. But the pattern changed starting in 2014–2015. In that period and each subsequent one through 2022–2023, the opportunity cost of excluding the 10 biggest contributors outweighed the gain of excluding the 10 biggest detractors. The performance shortfall averaged perhaps 1%–2% and reached about –5% in 2020–2021. The chart also shows the performance difference between large- and small-capitalization U.S. stocks. Small-caps performed better in six of the first seven periods and in seven of the first nine periods, by amounts ranging from roughly 2 percentage points to about 16 percentage points. Since 2018–2019, large-caps have topped small-caps in each period—by roughly 5 percentage points per period, on average.

Note: The return of large-capitalization stocks is simulated by the return of the largest one-third of stocks in our Russell 3000 Index replication, while the return of small-cap stocks is simulated by the market-weighted return of the smallest two-thirds of stocks in that index replication. Each two-year dataset reflects the full 24-month period.

Source: Vanguard, as of December 31, 2023.

The circles in the chart suggest that the relative importance of contributors and detractors coincides with the return differential between large- and small-caps. When large-caps underperform (that is, when the dot is below the x-axis), the gain of not holding the biggest detractors tends to exceed the loss of not holding the top contributors. Conversely, when large-caps outperform (that is, when the circle is above the x-axis), the loss of not holding the top contributors tends to exceed the gain from not holding the biggest detractors.

The data reflect how large-caps dictate the market’s “direction of travel.” This makes intuitive sense, because a stock’s contribution to the market return is a function of the stock’s return and its market weight. If two stocks deliver the identical return in a given period, the one with the higher market weight will contribute more to the market return.

Success in active portfolio management is possible but not simple

Of course, had one correctly predicted the (change in) performance of large-caps versus small-caps or the rise of the Magnificent Seven, one would have easily outperformed the market over our study period. But we know from numerous studies on the performance of professionally managed active funds how difficult an undertaking this is.

Our findings should be a reminder of the challenge of market timing. For active investors who are not comfortable with market timing, diversification and maintaining discipline can improve their chances of outperforming.

1 Sources: Vanguard calculations, based on monthly holdings, market capitalization, and return data from FactSet Research Systems as of December 31, 2023. The Russell 3000 Index is a broad measure of the U.S. stock market.

2 A stock’s contribution to an index return is generally determined by the product of its weight and return. Our analysis adds the additional effect stemming from redistributing an excluded stock’s weight across all other stocks in the portfolio. For clarity, this article refers to a stock with positive contribution as a contributor and to a stock with negative contribution as a detractor.

3 Specifically, we calculated the contribution of individual stocks to the market’s result by subtracting the return of the “Russell 3000 excluding stock n” from the return of the Russell 3000 itself. The “Russell 3000 excluding stock n” is calculated by distributing the weight of the excluded stock across all remaining stocks in proportion to their market capitalizations. In selecting two years as the length of each subperiod in our study, we sought to balance the need for adequate period length and an adequate number of nonoverlapping periods.

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Notes:

All investing is subject to risk, including the possible loss of the money you invest.

Past performance is no guarantee of future returns.

The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Diversification does not ensure a profit or protect against a loss.

Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks.

CFA® is a registered trademark owned by CFA Institute.

Contributors

Jan-Carl Plagge, Ph.D.
Jan-Carl Plagge, Ph.D.
James J. Rowley Jr., CFA
James J. Rowley Jr., CFA
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