The changing face of diversification
I have spent an awful lot of the past 30 years saying basically two things - don’t try and time the market and be well-diversified. Both of these investment mantras are interesting in part because it is so easy to make a superficially attractive case against them.
The first part of the counter argument is that buying low and selling high can make you a lot more money than timidly dripping your money into the market on a regular systematic basis. The Nasdaq index is up more than 60pc since March. Why would you not try and time that rally? The second part of the case against is that if you can buy just the best-performing stock, sector, or market, you’ll be better off than if you carefully place your eggs in a variety of baskets. Over the past six months, Tesla has more than doubled while the US market as a whole has just returned to where it started. Picking the winner has done twice as well as spreading your bets.
The trouble is, of course, that doing either of these things consistently is impossible, which is why prudent investors opt for the safer, if ultimately a bit dull, approach of investing regularly and systematically into a balanced portfolio.
The recent past has rather rubbed it in that sensible investors pay a price for erring on the side of caution, especially when it comes to diversification. As Apple’s market value burst through $2trn last week, it was widely observed that the top five stocks in the S&P 500 index have accounted for 25pc of all the gains in the market since the March bottom. Not owning these shares will have more or less guaranteed that you have fallen behind the US market as a whole. The difference between being an investment genius and a fund management failure has essentially boiled down to one decision.
Apple, Amazon, Alphabet, Microsoft and Facebook now account for more than a fifth of the total value of the US benchmark index. Just a year and a half ago, this handful of tech giants represented less than 15pc of the S&P’s total capitalisation; today it is 22pc.
This is a bigger slice of the whole for the top five shares than at any time since at least 1980, and even more than during the dot.com bubble when tech stocks last dominated to this extent.
At times like these, investment seems simple to many people who had not given it a great deal of thought until they noticed their friends and family making apparently easy money. This is precisely the time that tried and tested mantras like the ones on timing and diversification get ignored. And it is precisely the time when they are most valuable.
History has not been kind to late arrivals in over-concentrated markets like this one. The bear market of 2000-2002 which followed the bursting of the dot.com bubble saw shares fall at a compound rate of 14.6pc a year for three years. Interestingly, you could have avoided much of this pain by holding a diversified portfolio. While big tech stocks were collapsing, smaller value shares delivered a compound annual return of 12.2pc. In 2008, when US shares fell by 37pc, US Treasury bonds rose by 26pc, although the value of diversification by asset class has been less obvious recently in the latest ‘bull market of everything’.
The transformation of the S&P500 into a bet on the continued dominance of Silicon Valley is a reminder that there is more to diversification than simply buying an index tracker fund.
We have known this for a long time here in the UK, where it is recognised that the FTSE 100 is not just a poor reflection of the UK economy but a very narrow proxy even for the stock market. Strip out one bank (HSBC), and the top ten companies in the UK benchmark come from just three sectors: pharmaceuticals, extractive industries (oil and mining) and consumer staples. Astrazeneca and Glaxosmithkline alone account for 12pc of the value of the FTSE 100. Just as they do in America, the top five stocks in the UK market represent more than a fifth of the total value of the benchmark.
In some smaller stock markets, the concentration is even more striking. When Nokia was a force to be reckoned with in mobile phones, the company dominated the Finnish stock market. Even in the much better diversified German market today, SAP, Linde and Siemens account for more than a third of the DAX 30’s total value.
So, diversification by geography matters, but possibly not in the way that we thought. Investing in a variety of stock markets around the world may not necessarily provide you with an exposure to a range of different economies but, thanks to the increasing bias of some markets to just a handful of industries, it could provide useful sector diversification. Investing in Japan and Germany gives exposure to global manufacturing, the UK to pharma and mining and the US to technology.
Two other forms of diversification may be worth a look. Size is from time to time a significant differentiator. In the late 1990s big was beautiful and this time around, too, it has been an advantage. If you had invested $100 five years ago in the S&P 500 index it would be worth $166 today. The same $100 in the Russell 2000 smaller company index would be worth just $133. If the big tech stocks falter, that difference is likely to narrow.
The other feature of a well-diversified portfolio is a range of investment styles. A shared characteristic of the best-performing stocks in recent years has been their ability to deliver consistent earnings growth. Attractive valuations have been much less important. But styles come and go. The time to diversify is when no-one thinks it is worth bothering.
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Tom joined Fidelity in March 2008. He acts as a spokesman and commentator on investments and is responsible for defining and articulating the Personal Investing business’s investment view. Tom is an expert on markets, investment trends and themes.