When 'diversification' stops being diversified

Anyone following the financial headlines could be forgiven for thinking concentration risk is a uniquely American problem.

Investors have been right to worry about the dominance of the mega-cap technology companies in the S&P 500 and MSCI World indices, where a narrow group of market leaders continue to push major global indices into record territory.

Yet Australia's own concentration problem is at least as significant - and arguably more consequential for local investors who assume their domestic equity allocation is providing genuine diversification.

For investors buying the S&P/ASX 300 Index today, the reality is that they are taking a very large exposure to a narrow group of expensive, crowded stocks. Almost 50% of the index now sits in just 10 stocks, seven of which are banks and miners.

That is not broad diversification but a concentrated exposure to a handful of companies whose fortunes are heavily tied to Australian credit and commodity cycles.

Financials and materials together comprise almost 60% of the S&P/ASX 300 Index. In 2026, that dominance has been obvious. The top five stocks by market capitalisation - BHP, CBA, NAB, Westpac and ANZ - together contributed 9.5% to the benchmark's relative performance over the three months to 31 May 2026.

By contrast, the remaining 295 stocks in the index detracted 2.4% over the same period, while the index as a whole rose just 1.4%.

That tells us that money is continuing to crowd into the largest index names, while large parts of the Australian sharemarket are being ignored.

Buying a passive index-tracking fund may feel diversified, but the reality is it leaves portfolios heavily exposed to a small group of expensive, highly correlated stocks.

Concentration is not the only issue

Concentration alone is not necessarily a problem. A company can become a large part of an index because it has earned that position through superior profitability, disciplined capital allocation and sustained earnings growth. Investors should not automatically avoid large companies simply because they are large.

The more important issue is price relative to the longer-term earnings trajectory of these companies. A great business can still be a poor investment if the price is too high. Equally, a company facing short-term challenges can become attractive if expectations have fallen far enough and the valuation already reflects a large amount of bad news.

That distinction is critical when it comes to finding value on the ASX. In some cases, investors are paying very high prices for perceived safety and index leadership, while overlooking many companies where the outlook is more clouded at first glance: either valuations are low, earnings are depressed or sentiment is already deeply pessimistic.

Commonwealth Bank (ASX: CBA) is a useful example of this dynamic. CBA is unquestionably a high-quality business, with resilient earnings and a long record of profitability. But its valuation now implies a great deal of confidence in those dynamics continuing indefinitely.

The contrast with CSL (ASX: CSL) is striking. There was a time when the market appeared willing to pay almost any price for CSL's perceived quality and growth. Today, sentiment has swung in the opposite direction. CSL faces real issues, including pressure on margins and concerns about the outlook for parts of its business. Those risks should not be dismissed.

But the question for investors is not whether a company has risks. Every company does. The question is whether the price reflects those risks.
At current valuations, the market appears to be applying very different standards to different parts of the ASX. It is prepared to pay a high price for companies perceived as safe and familiar, while heavily discounting businesses where the outlook is more uncertain. That creates opportunity for investors willing to look beyond recent share price momentum and index weight.

Price still matters

Markets have a habit of making investors feel most comfortable when risk is highest. When money crowds into the same companies, sectors and themes, it can create the impression that those areas are safe simply because everyone else owns them.

But popularity is not the same as safety. Size is not the same as diversification.

In markets, price always matters - and history shows it tends to matter most when others have forgotten that it does.