Stock Market Concentration

To approximate a value-weighted portfolio of all wealth, one should overweight public assets that are similar to private assets - such as small firms. This is not because of concentration in the public indices per se, but because some assets are missing from public markets.

The average investor holds the market-cap weighted market portfolio. Period. Anything else is a zero-sum game. You'd better hope you're smarter than the person on the other side who thinks he's smarter than you. Or, more reasonably, have different risk exposures.
-see background information here

The entire point of indexing is respecting market valuation. Absent other information about returns, I see no reason to move from market weights just because of concentration.

relative performance of stock returns across countries is notoriously difficult to forecast, e.g., Japanese equities continued to outperform for two decades in 70s-80s.

It's not obvious one way or the other, but I am not aware of evidence of the suggested benefit. Moreover, the market equilibrium might be weird and highly inefficient if the majority of diversified investors stray far from market-cap weighted portfolios.

For diversification, value weights capture the whole market, at least among market-traded assets.

To avoid the idiosyncratic risk of the top 10 stocks, you can just use an "S&P 500 - 10", i.e. the S&P 500 minus the top 10 stocks. It's still market-cap weighted, so avoids rebalancing costs. Now the shocks to the top 10 firms shouldn't be avoided -- they're part of total risk.
-see background information here

If there is any deviation from fair prices, weighting by capitalization means you overinvest in overvalued stocks and underinvest in undervalued stocks - by definition. Deviation from cap-weight is a bet on market inefficiency. There are relatively passive (ETF) ways to do this.

Limited historical episodes of extreme market concentration and excess predictability

As a rough approximation if we suppose that the “magnificent 7” and a relatively small number of other stocks proxy for market volatility, then the answer to the question would seem to depend on whether firm-specific volatility among the remaining stocks has gone up or down

The market portfolio is what it is. More or less concentrated. So unless the indexes are not representative of the true market portfolio, why deviate? There is also a difference between partial equilibrium and general equilibrium...we cant all deviate the same way and still clear

Theory tells you that market cap weights are the most passive and best approach (also true from a trading cost perspective). Also, depends on what is meant by "passive". If passive means everyone can hold it simultaneously, then market cap is the only passive.

The Two-Fund Separation Theorem

in general no, but exposure to same underlying technology could justify down-weighting the top 5

Top 7 stocks account for the majority of returns + represent over 30% of the index. Unlike previous episodes (tech bubble)these firms are highly profitable, have lots of cash and high expected growth. Reweigh tilts toward smaller stocks (weaker growth). Not for passive investors.

Quite possibly, yes, for investors seeking a "well-diversified" portfolio. The classic argument for holding the market portfolio (i.e., the CAPM) is that it's a mean-variance efficient portfolio, whether or not it's a well-diversified portfolio.

I guess they should consider it, though not sure what they would conclude. It depends on their objective.

The question is confusing. I think that investors should consider alternative portfolios, but this does not mean that they should necessarily under weight the largest stocks. Maybe they should -- but maybe not.

As firm values fluctuate, the vw portfolio automatically rebalances and reflects the importance of each stock in the overall market portfolio.