A recent article in The Economist caught my attention, and I wanted to share its message with you. The article is titled “Most stock market returns come from a tiny fraction of shares”. And its message is simple: Don’t go chasing hot stocks; instead, stick to your financial plan and your portfolio will do just fine. Let me walk you through the reasoning.
FAANG Stocks Powered Nasdaq Gains
The article first talks about FAANG stocks. The acronym FAANG is based on the first letters of Facebook, Amazon, Apple, Netflix, and Google. These tech giants have been on fire since March 2009, and they have powered the bulk of the Nasdaq’s gains over the past nine years of this amazing bull market.
Dominance Of A Handful of Stocks
Historical data shows dominance of a handful of stocks. A paper by Hendrik Bessembinder of Arizona State University corroborates this. It shows that since 1926, most stock market returns in America have come from a tiny fraction of shares. For example, just five stocks—Apple, ExxonMobil, Microsoft, GE and IBM—accounted for a tenth of all the wealth created for shareholders between 1926 and 2016. The top 50 stocks accounted for two-fifths of the total.
Double Or Nothing
Here’s how this works. Imagine there is an equal chance that a stock will rise or fall by 50% each year. A $100 stock that goes up 50% in year one would be worth $150; if it falls by 50% in year two, it is worth $75, less than when the game started. In contrast, a lucky stock that rises by 50% in two successive rounds is worth $225. After many rounds, most stocks lose money. But a few stocks make a lot of it.
Does this consistent increase in stock value, year after year, remind you of one of my pet phrases? Yesss…it’s the magic of compounding, which can grow wealth phenomenally. So stocks such as Apple, Exxon, Mobil, Microsoft, GE, and IBM increased year after year and went on to drive wealth creation.
And get this, more than half the 25,000 or so stocks listed in America over the past 90 years proved to be worse investments than Treasury bills. Imagine that! Half of all listed stocks delivered returns that were less than returns from highly safe investments in U.S. Treasuries. So here’s something that vindicates holding Treasury bonds as part of a well-diversified portfolio.
Back to today. All FAANG stocks hit new record highs in the month of July. However, these stocks have recently come under some pressure over the past few weeks. Investors now appear to be locking in their tremendous gains and selling on less than stellar news.
State Of The Market
Let me segue from the article for a moment to talk about what’s going on in the market.
To some extent, I think recent pullbacks reflect some fatigue with the bull market. This could just be the kind of breather that the market needs from time to time before it charges back up again. On the flip side, a lot of pundits on Wall Street are now talking about a bear market hitting us in the second half of 2018. Their reasoning is that valuations are high, second-quarter earnings are out, and the strong 4.1% GDP growth number is already on the table. But far be it from me to predict the demise of this bull market. For now, I plan to take a wait and see approach.
Okay, back to the Economist article titled “Most stock market returns come from a tiny fraction of shares”.
The article speaks of a tug-of-war in the market. On the one hand, you have bullish investors who want you to jump on the FAANG bandwagon, eyes closed, no matter how high the valuations stand today. This camp believes that FAANG stocks are about where our future is headed. Hence, owning FAANG makes far more sense than chasing stodgy stocks in dying industries.
On the other hand, you have people who shun the mania of acronym-laden, over-hyped Wall Street darlings, such as FAANG stocks. These high-minded investors would rather stand apart from the herd.
I, for one, don’t side with either of these extreme views. As I have been saying on my Intelligent Investor series, investors must look for shares that offer a margin of safety and future upside. I do not believe one should shun FAANG stocks simply because they are all the rage. I also do not believe one should buy FAANG stocks without analyzing their margin of safety and fundamentals-based future growth potential.
I believe it’s important to buy shares that fit your long-term investment goals, be they one or all of the FAANGS or a completely different basket altogether.
To wrap up, here’s the bottom line.
There is no guarantee that today’s winners—the FAANGs—will still be winners tomorrow. As Benjamin Graham believed, if you overpay for a stream of earnings, however good the company is, you cannot hope to make money from investing. So, make sure you analyze FAANG or other hyped-up stocks before you add them to your portfolio.
If you’re like most investors, you won’t really be able to predict the next Google or Amazon or be able to time the market perfectly. So, my advice to you is to hold a broad index of stocks as a combination of index funds and high-quality stocks. And add bonds and cash as part of your overall diversification strategy.
This middle-of-the-road approach might appear to lack personality. Yet, it is the right approach to create long-term wealth through investments.
Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. There are no investment strategies that guarantee a profit or protect against loss. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however, their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by the radio show.