Jun 10, 2020 | EWAN ROSIE

Mitigating an unknown future

Last week we spoke to you about stock picking in our blog, Portfolio Pick ‘n Mix. This week we’re drilling further into why this is a bad move and how you can mitigate an uncertain future in other ways.

One of the hardest concepts to grasp in investing is that a ‘good’ company is not always a better investment opportunity than a ‘bad’ company. Markets work well – not an unreasonable thing to believe given that few investment professionals beat the market over time*1. And, as discussed last week, they incorporate all public information into prices pretty quickly and efficiently. This means all of the ups and downs are already reflected in prices.

A ‘good’ company will have to do better than the expectation set by the market for its share price to rise and vice versa. If a ‘bad’ company is in fact a less healthy company, it may have a higher expected long-term return, as risk and return are related – our second guiding investment principle.

Our third principle is all down to making sure all your eggs aren’t in one basket or in other words, diversification. In an uncertain world, where stock prices could move rapidly on the release of new information, it makes good sense to ensure that an investment portfolio remains well diversified across companies, sectors and geographies. It’s perhaps evident that if the market incorporates the forward-looking views of all investors, it becomes very difficult to choose which companies, sectors, and geographic markets are likely to do best, going forward. Take a look at the chart below that illustrates how deeply diversified a globally equity portfolio can be*2 – each colour represents a different company, and the size of the company in the portfolio/index.

 If you do not know which stocks are going to outperform well, own them all…

Source: Albion Strategic Consulting.  Data: Morningstar Direct © 2020.  All rights reserved.

The US’s S&P 500 is increasingly concentrated in a few names…

Source: Albion Strategic Consulting.  Data: Morningstar Direct © 2020.  All rights reserved.

As you can see the concentration risk in the US’s S&P 500, is quite different.

Given that all the future promise of a company is already reflected in its price today, it’s quite a risk betting a large part of your assets on just a few names, concentrated, for example, in the technology sector. The top 8 technology stocks in the US now have a larger market capitalisation than every other non-US market except for Japan.

Who is the next Amazon? What regulatory pressures could current dominant companies face? No-one knows.

By remaining diversified, you will own the next wave of market leaders as they emerge and dilute the impact of natural ebbs and flows in the market. Whilst it’s always tempting to look back with the benefit of hindsight and wish we had owned more, it’s more important to focus on what matters to you now and in the future.

‘The safest port in a sea of uncertainty is diversification.’Larry E. Swedroe, Investment Author

 

*1 For example see SPIVA US Year-end Report – 15 year data where around 90% of manager fail to beat the market.
*2 An illustrative global equity portfolio that includes small tilts to value stocks, smaller companies, global commercial property, and emerging equity market shares.

 

Past performance can’t guarantee what investments will do in the future. The value of a portfolio can go down as well as up, so there’s a chance you’d get back less than you put in.

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