When people hear about diversification, they don’t necessarily start jumping for joy in excitement. The word itself has a connotation of taking a measured, patient approach to things. In today’s world of instant gratification and get-rich quick schemes, diversification can sound boring and unexciting. But it really is something we should be excited about.
Concentration and Recency Bias
Extreme concentration in investing can lead to amazing outcomes, or it can lead to catastrophic outcomes. Most people like the idea of hitting it big, and so they try to find concentrated solutions that will grow their money quickly. But the certainty of success with concentrated ideas is low. So to summarize: The more concentration, the more potential for larger gains or larger losses. In addition, the more concentration, the lesser degree of certainty you have of success.
With diversification, things are different. Although diversification can impact your ability to “hit a home run” right away, consistently hitting singles and doubles can lead to better outcomes over time. Boring, I know. With diversification, you may limit your upside to some degree, but you also mitigate the downside. And your certainty of success is a lot higher with diversification than it is with very concentrated investments. There is no guarantee in investing, but diversification can help increase our odds of success over time.
Over the course of history, the media has often put an emphasis on specific groups of stocks. Usually, someone coins an acronym or title representing a few companies that have recently had good returns. If one of the companies starts to lose its luster, or if a new one starts to emerge, things may change. For example, the “FAANG” stocks (Facebook [now Meta], Apple, Amazon, Netflix, and Google [now Alphabet]) became popular in the past decade. But that acronym didn’t include Microsoft, so there was a new variation of “FANMAG”. But that acronym didn’t include Tesla or NVIDIA, so now people talk about the “Magnificent 7” stocks (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla). But even recently, Geoff Colvin of Fortune claimed, “Without hardly anyone noticing, a tech titan you’ve probably never heard of has booted Tesla out of the heavily hyped Magnificent Seven… The overlooked Magnificent Seventh is Broadcom…”
Regardless of who is in the Magnificent Seven, or what new acronym or group of stocks will emerge in the future, many people assume that’s all they need to own to be successful in investing. But people don’t recognize the concentration risk they are taking, and that there are so many other great companies out in the world that could benefit you.
People may also forget (or not even know) that even recently, these companies haven’t always had stellar returns. Just look at their returns in 2022 (all return data provided is total return, sourced from Morningstar):
Alphabet Class A (GOOGL) -39.09%, Amazon (AMZN) -49.62%, Apple (AAPL) -26.32%, Broadcom (AVGO) -13.43%, Meta (META) -64.22%, Microsoft (MSFT) -27.94%, Netflix (NFLX) -51.05%, Tesla (TSLA) -65.03%, and NVIDIA (NVDA) -50.26%
Even more recently, as these companies have done well and garnered a lot of attention, people overlook other potential good investments. Samir Parekh, a portfolio manager at Capital Group, wrote an article last month about a group of stocks that has recently done better than the Magnificent 7:
“European banks have had a stellar run, significantly outpacing the Mag Seven group of U.S. technology leaders and the S&P 500 Index. The MSCI Europe Banks Index has returned 63.6% through August, on track for its best calendar year since 1997. By comparison, the Mag Seven returned 9.9%.
Admittedly, this is a short period, but it’s a good reminder of the benefits of a broadly diversified portfolio. Even the most maligned sectors can rebound, and they often do at times when beloved areas of the market are pulling back, helping to smooth out overall returns.”
These are examples of why we diversify our portfolios, and why we like to consistently rebalance them. We also understand that many popular companies, like those in the Magnificent 7, are some of the best companies in the world and are an important part of portfolios. We want to own these, but we just don’t want them to be our only holdings. We know that we can’t predict the near future with individual stocks, and so using broad diversification and rebalancing can help us avoid some of the worst outcomes of investing in extremely concentrated groups of stocks.
Is There Such a Thing as Over-Diversification?
Yes, absolutely. We understand this. Just as there can be problems with being overconcentrated in investing, there can also be problems with being “too diversified.” For example, if we owned 10,000 companies that all had 0.01% of our portfolio in them, that could lead to subpar returns, as no companies could have a significant impact on overall returns. So there is a balance in portfolio construction. It just seems that the scales have recently tipped too far on the side of overconcentration. But when stocks go down, that overconcentration is very dangerous. We want to protect you from that.
But Doesn’t Diversification Require Patience?
Yes. You have to be patient, which in today’s world is very difficult. But the best things in life require time, work, and patience. Although it may not be the most exciting thing to talk about, we believe in the value of diversification in investing, and that growing and preserving capital truly is an exciting thing.
Sources:
https://fortune.com/2024/10/05/broadcom-tesla-magnificent-7-companies-market-cap/
Disclosures:
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Stock investing includes risks, including fluctuating prices and loss of principal.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.