Diversify when you don't feel like it: how an investor can get rid of euphoria

Last week's selloff in tech giants' stocks after an impressive rally brought to mind the most important principle of prudent investing - diversification. During periods of market euphoria, when individual companies or sectors show dizzying growth, it is often forgotten. Fascinated investors hold one or a few stocks in their portfolio. Such concentration is a dangerous trap that not only jeopardizes the entire capital, but also deprives the investor of peace of mind.

Not everyone realizes the risks even at the level of the simplest calculations. For example, if the price of a stock rises by half, it only needs to fall by a third to completely deprive the investor of the profits earned.

If it is the only stock in the portfolio, the investor will be left broke. If it is one out of 100 stocks, he will "go to zero" on only one hundredth of his capital. If he holds an index fund with hundreds of stocks, he may not earn that 50% as quickly, but he won't lose it either.

The risks of concentration are well illustrated by private funds, many of which are created by company owners investing in their own securities. About 10% of the roughly 300 such organizations in the U.S. with more than $500 million in assets hold at least 30% of their portfolio in a single stock, writes Jason Zweig, who writes the Intelligent Investor column in The Wall Street Journal, citing data from FoundationMark, which tracks such funds.

Among them, of course, there are phenomenally successful examples, such as the fund of Nvidia CEO Jensen Huang and his wife. As of the end of 2019, it had $378 million invested in shares of this GPU maker. By the end of 2023, according to the latest tax return, assets had grown to $3.4 billion (and that's including a $170 million payout in grants). This was largely due to Nvidia's stock rising 745% over that period.

This year, thanks to the euphoria associated with the development of artificial intelligence, it became the first company in world history whose capitalization exceeded $4 trillion.

But unless you're an investment guru like Warren Buffett, or an equally brilliant entrepreneur like Jensen Huang who can rely on himself and the businesses he's created, you shouldn't choose one or more of the many companies, Zweig writes.

"Any investor should remember the old maxim: diversification is the best course of action at the very moment it appears to be the worst."

As an example, he cites shares of apparel and footwear maker VF Corp. (Vans, The North Face, Timberland brands), which has delivered an average annualized return of 21.9% over the 10 years through the end of 2019; by comparison, the S&P 500 index has returned 13.6% over the same period.

At this time, the family foundation of company founder J.E. Barbey 8 FBO Tenacre Foundation held almost everything in VF stock - $3.1 billion out of $3.3 billion. Everything was going well, but then VF stock went downhill and lost 78% in value by the end of 2023.

This is far from an isolated example, Zweig notes. At the peak of the Internet bubble that inflated in the late 1990s, Internet hardware maker Cisco Systems was Nvidia's counterpart at the time.

Since its initial public offering in 1990, its stock price has risen more than 1,000 times, and in March 2000, Cisco overtook Microsoft to become the world's most valuable company. Its market capitalization reached $555 billion, and its shares reached a record high of $80.06.

The stock is now about 16% cheaper - it has not returned to that record level in a quarter of a century. At the peak, investors were so excited about Cisco, which was actually building the infrastructure of the Internet, that its P/E ratio reached almost 190.

A similar story may be happening today with some technology companies. For example, the shares of data analysis software developer Palantir, whose main customers are the military, intelligence agencies, investment banks and hedge funds, have become very popular with investors. Over the year, Palantir's shares rose by almost 400%.

Quotes peaked on August 12, but then collapsed by Wednesday by almost 17% in six trading sessions of non-stop decline.

Despite this, Palantir stock is still the highest YTD return among S&P 500 index companies at 106%.

But the relentless growth that has brought the company's P/E ratio to more than 520 - 2.7 times what Cisco's was at its peak - has begun to attract downside players.

The number of short positions on Palantir has increased by about 10 million shares, or 0.4% of the free float, since early June, Bloomberg cites data from S3 Partners, which tracks such information.

There is a downtrend in Palantir's shares, and if the quotes rise, the number of downside players will only increase, says Vikram Rai, portfolio manager at Fny Capital Management.

At the same time, investor sentiment has changed not only toward Palantir, but perhaps toward the technology sector as a whole. "The sell-off in Palantir's stock is long overdue and not just because the shorts have taken over" from buyers, says Rai. When companies such as Google, Meta and Microsoft fall, it's obvious that the securities of other popular but smaller companies in the sector, which typically rise and fall faster, "will fall much harder," he says.

In recent days, investors have been locking in profits on strongly rising shares of technology giants, shifting into cheaper securities that have lagged behind popular leaders in terms of growth rates.

No longer able to ignore the off-the-charts quotes, "a correction in tech stocks is overdue, because you can't spend so many days and months relentlessly buying up shares of the same group," Chris Bertelsen, chief investment officer at Aviance Capital Management, told Bloomberg.

The US stock market is "in the early stages" of a bubble, although the time for a full-blown correction has not yet arrived, according to Howard Marks, co-founder of hedge fund Oaktree Capital Management.

"Increasing your investment in a stock when it's at its peak is a particularly bad idea because very few companies allow investors in their stock to make money in the long run," Zweig warns.

A study by Hendrik Bessembinder, a professor at Arizona State University's business school, says as much.

He analyzed the returns of all companies whose shares were traded on the U.S. stock market from 1926 to 2019 (there are more than 26,000 of them) and compared them to the returns of one-month Treasury bills, the instrument considered the most reliable. Only 42.2% of companies have allowed their shares to earn more on their stock than on a risk-free investment during their time as a public company. The rest did not justify the risk taken by investors. And half of the total return, totaling a combined $47.4 trillion, came from just 83 companies, or 0.32% of those ever traded. From a sectoral perspective, technology stocks were the biggest gainers - $9 trillion (almost 19%).

That is, the chance to choose the right stock that will bring income above the market (or even just above zero), and also to fix the profit on them in time is extremely small.

But psychology often makes you bet on concentration. After taking the time to study a company, and especially after receiving a good paper profit after its purchase, an investor begins to consider himself an expert. He believes in further continuation of growth, also because he is afraid of missing additional profits. At such times, diversification seems unnecessary and harmful.

But "the bigger your recent gains and the more unreasonable diversification seems, the more important it will prove to be" in the not-too-distant future, Zweig insists.

To avoid portfolio concentration errors, an investor can set a specific proportion for an asset, such as 5% for each. "That way, you'll make a lot of money if you make the right bet, but you can't ruin your financial future if you get it wrong," Zweig explains.

If this proportion is exceeded as a result of an increase in the value of the asset, a rebalancing should be carried out. This can be done, for example, once a quarter or a year. An appreciating asset can be sold to bring its share back to the target, and something undervalued or severely depreciated (but fundamentally attractive) can be bought. The latter is a classic principle of smart investing.

This article was AI-translated and verified by a human editor