Previously published in The Bulletin on December 24, 2023
Allow me to paint a picture for you. There are two portfolios: Portfolio A is up 20% in one year. Portfolio B is up an astounding 100% during the same period. Much of the financial news is talking about Portfolio B and how stellar the returns are. They say, “These companies are innovative and visionary. They are driving economic growth.” Investment returns are like Christmas cookies, most people want more. Even though Portfolio A provided a healthy return, anyone would prefer Portfolio B. This is the true story of investing in the stock market in 2023. Portfolio A represents the S&P 500 Index. Portfolio B represents the so-called “Magnificent 7” stocks: Alphabet (GOOGL), Amazon (AMZN), Apple (AAPL), Meta (META), Microsoft (MSFT), Nvidia (NVDA), and Tesla (TSLA).
Much has been made of the dazzling 2023 performance of the Magnificent 7. Through November 2023, the Magnificent 7 were up 105% on the year while the remaining 493 companies in the S&P 500 were up just 7% during the same period (using equal weighting). That is a staggering disparity that has led many investors to question their current investment strategy and ask what to expect moving forward.
It is easy to find anomalies in investment returns when looking at short time frames. In the 1600s, the value of a single tulip in Holland famously skyrocketed to an estimated $1,000,000, in today’s dollars, before predictably plummeting back to reality just a few months later. Despite the outlandish returns in 2023, the Magnificent 7 performance is quickly brought back down to earth by considering last year’s results. At one point in 2022, the Magnificent 7 experienced a loss of -48%. In comparison, the S&P 500 reached -25% in October of 2022. Still painful, but much easier to stomach as an investor. When looking at the combined performance of the two years, the Magnificent 7 narrowly beats the index.
Most investment professionals would wisely tell you that two years of performance is also too short of a track record to properly evaluate an investment. To their credit, the Magnificent 7 have largely had strong performance when looking at the last decade. Presumably, the value of these tech giants is unlikely to pop like the Dutch Tulip bubble. To say that investors should avoid these stocks completely would be foolish. However, it is critical to keep this volatility of returns in mind when comparing investment options. While the explanation for the extremes in returns can be traced to a few variables, a lack of diversification stands out as a major factor. A portfolio comprised of seven companies that are arguably all concentrated in the same industry is a risk that investors should be aware of. Analyzing performance numbers is straightforward, but risk is a more abstract element to measure. Contrasting the Magnificent 7 against a diversified portfolio or a broad index is an unfair comparison similar to apples and oranges.
Rarely are the pros and cons of stock picking as apparent as they are currently. To capture the upswing of a risky stock without experiencing the downside volatility is an investor’s fantasy that requires impeccable timing. But if you are risk-happy enough to try, consider how much risk your financial situation allows. For most investors, a balanced approach is prudent. It may be okay to have some Christmas cookies, but if you do not leave room for a well-balanced Christmas dinner, you may find yourself regretting that decision later.