The Stock Market Did Great This Year
Yet Everyone is Nervous About It
They’re worried because the gains have nearly all been from just a select few companies.
That concentration is scaring people and many of them are looking for ways to diversify.
I think that’s foolish.
Concentration is feature of good diversification. Not a bug.
It doesn’t scare me, and I don’t think it should scare you.
The first person to put me on this topic is the Psychology of Money author Morgan Housel.
His blog post called “Tails You Win” explains that big outsized winners (Tail Events) are what drive the growth of our diversified portfolios.
His argument would be that the S&P being over-concentrated in winners means it’s operating like it’s supposed to.
Interesting right?
60% of the S&P 500 returns in the last 3 years came from 10 stocks.
For those bad at math that means 490 companies combined returned less than the 10 great ones.
But 5 years ago, we didn’t know which 10 those would be. That’s why we diversified into a basket of 500 stocks.
It’s easy to assume diversification is so you can benefit from all 500 stocks slowly rising.
But it’s actually so that when a small group of those 500 go bonkers we look back and realize “Nice! We’ve owned those stocks the entire time.”
Those bonkers stocks drive the returns of the entire portfolio.
If you’re thinking this sounds more like Venture Capital investing than index investing, you’re right.
I had no idea how similar the return profiles were between the two.
Even if we are “less risky” because we’re investing in established companies as opposed to start-ups, our returns are still reliant on a few Tail Events, just like venture.
Even Warren Buffet is a believer in this
He’s owned 400-500 stocks during his life. Yet he’s quoted saying most of his money has come from 10 of them.
If you remove just four companies from his portfolio:
- Apple
- Coca-Cola
- American Express
- Geico
Buffet isn’t Buffet.
Risky and concentrated? Nope.
Diversified.
So I think it's a bit dumb that people are changing course.
Young, Long-Term investors are looking for ways out of the investments that have made them so much money the last few years.
Will tech eventually crash and bring down the market? Probably.
But pulling out of the market is silly because you both:
- Guarantee you miss out on returns if the bull run keeps going
- Lose your wide-net of diversification to catch the next 10 great companies in the next bull run (people think they’ll time the bottom of the market. Studies show they almost never do).
Diversification helps drive Concentration which drives Maximum Long-Term Returns
But remember, our goal as investors is not just to maximize returns.
It’s to maximize returns a) At a timeline that fits your goals and b) At a volatility that you can stomach
If you need some of your investment money in the next 0-5 years, you shouldn’t be solely in the S&P 500.
You don’t have time for the market to crash and then slowly come back.
Similarly, if you can’t handle seeing 40% of your net worth disappear (knowing it will eventually go back up), then you shouldn’t be solely in the S&P 500 (I’ve written about this here).
Everyone in the financial media world is currently figuring out how to avoid concentration.
They want to change strategies and go to things like equal-weighted S&P funds or moving to all cash until things “calm down”.
History would say those people are wrong.
For now, I’m keeping my cool while people are losing theirs… let’s see how this plays out in the long run.
