 | | ILLUSTRATION: TAMMY LIAN FOR THE WALL STREET JOURNAL | | |
Week 4: One Basket Is Fine, but Fill It With Many Eggs | | |
| Why settle for average when you keep reading about people who made life-changing stock picks and made millions? It's such a tempting daydream because it wouldn't have taken Master of the Universe-level genius to beat the market over the past few years. | | |
| Two of the best-performing S&P 500 tech stocks from 2012 through 2016 were Netflix and Nvidia. If you had just owned those stocks since then, you would have clobbered the index by a lot, thanks solely to the strength of Nvidia. Most people intuitively understand the benefits of spreading their bets in the stock market, or what is called "diversification." If you're seeking green M&M's, grabbing a big handful from the bowl is a much better way to be sure you get a green than just picking one M&M blindly. For investors, that means buying an index fund rather than just a single stock. But again and again, so many people don't take this basic precaution and instead try to find those green M&M's on their own. A study looking at tens of thousands (PDF) of individuals' portfolios in the 1990s found that the vast majority were under-diversified. That can be in simple ways, like by just owning too few shares, or in slightly more complicated ways, like by owning too many shares that all move in the same direction under similar market conditions. Consider this: If instead of Netflix or Nvidia you had picked Facebook—now called Meta Platforms—or Google parent Alphabet at the end of 2016, you would have underperformed someone who bought the Vanguard Information Technology ETF. The fact is, picking stocks that will beat the market is actually really hard. Even if you get it right, it meant you took a lot more risk than you probably wanted to. This week, we'll show you exactly how hard it is to pick winners despite how easy some make it look. And if you're picking just a couple of stocks for your whole portfolio, you're not investing—you're trading. —Telis Demos, Heard on the Street columnist | |
| |
| This week's challenge teaches you about: Diversification. | | |
| |
| ⏰ Suggested time: 45 minutes Step 1: The box of colors. This box has green squares when you pick a mega winner stock based on the actual performance of stocks versus the Russell 3000 Index over four decades. Ones that beat the market but didn't shoot the lights out are gray. Ones that lagged behind the market, sometimes even losing all of its value, are red. | |
 | | ILLUSTRATION: JONATHAN SIMON FOR THE WALL STREET JOURNAL | | |
| Step 2: Learn the odds. This box wasn't concocted by magical thinking. The odds are based on a study from J.P. Morgan (PDF), which looked at the performance of stocks from 1980 to 2020 and compared them to the Russell 3000 index. It found that 66% of the stocks underperformed the index. Only 10% of the stocks were mega winners, defined as having a 500 percentage points or better price return versus the Russell 3000. Watching a stock go up like a rocket can be a thrill, but chances are pretty good that whatever is outperforming now might underperform down the road. Even winning stocks can have some downs on the way up. So in effect you're just adding another kind of risk, known as market timing. | |
| Step 3: Are you diversified? Take a look at your portfolio. Maybe you do own several stocks. Does that mean you're diversified? Perhaps not as much as you think. Consider how those stocks might all react to the same piece of news. Say, for example, self-driving cars were outlawed in a big state, or bitcoin's value plunged. Would all your stocks probably react the same to that news? To be effectively diversified, you'd want stocks that would react in the opposite way, too. | |
| Step 4: Sparking joy. Diversification doesn't mean you give up all the joy of watching a stock surge. Most index funds are weighted by the market value of their constituent stocks. As a stock rises, it increasingly drives the index's performance. You're not getting the full performance of that winner, but you're also getting some of the performance of winners you didn't see coming at all. And you're protecting yourself against the risk that you pick a complete loser. | |
| | ❓Questions to Ask Yourself❓ | | |
| 🤔 So should I just buy an index fund? If you're someone who is able to tolerate risk in your portfolio, by all means supplement an index fund with a few choice stocks, or maybe a more concentrated fund like one that just owns tech stocks. | |
| |
 | | PHOTO: PHILLIP FARAONE/GETTY IMAGES | | |
| The gist of the lyrics of "Your Song" by Elton John is that the singer doesn't have the money to buy a big house for his love, so he'll just write a lovely song. But think about that for a minute: Were you to in fact write and gift "Your Song" to someone, it would be an incredible present. It's a global hit single earning royalties for years and years. That could be worth far more over a lifetime than just about any house. It's a reminder not to mistake the cost of something for its discounted cash-flow value. | |
| |
- In May 2024, just four giant technology stocks added more market value than the rest of the S&P 500 put together. More than half of the gain came from Nvidia. What happens if investors' AI assumptions don't pan out?
- Even if there isn't an AI bubble, the rally is still risky.
- For a great illustration of single-stock risk, consider Peloton's transition from pandemic darling to basket case.
| |
| |
| 💡 COMING NEXT WEEK: Hit the road. | |
| |
