Recent tumbles in two tech stock giants make a point investors can't afford to forget: Moving money between stocks that are correlated is the opposite of diversification.
When I hear investors say something like "I'd take profits on Facebook and put that money to work in Amazon" I don't need to judge the merits of the investment worthiness of either stock, or the aptitude of those who say it, to be worried. It's hard for a stock to outrun the gravity of its sector; not an impossibility, but low probability.
There are signs that no tech stock is safe even if it isn't mired in a privacy scandal. The Wall Street Journal reported this week that big hedge funds are taking money out of tech, and "FANG" stocks in particular are being sold by big fund managers, according to Reuters.
Facebook and Amazon are part of the "FANG" (Facebook, Amazon, Netflix, and Google-now-Alphabet) stocks, the super-popular, widely held winners of the last few years and the stocks that fueled the market rally earlier this year. These companies are also part of the broader cohort of tech stocks that have outperformed, such as Salesforce.com, Adobe, and others.
The thing is, the tech sector's run of outperformance means the companies also will trade alike when they go down. If one is having an up quarter or year, most likely they all are, and vice versa. It makes individual stock selection less relevant and reinforces the notion that most of a stock's performance is correlated with its sector. So, if you're taking a profit on Facebook shares, what's the point of putting the proceeds into another tech stock that also rose a lot?
Sure, you could not have known that the day you moved your money from Facebook to Amazon the president of the United States would decide to ignite a Twitter war against Amazon founder Jeff Bezos, but that's not the point. You might as well hold onto the Facebook stock or shift the proceeds into a different sector.
Investors in the Facebook or Amazon crosshairs need to start with one question: do you own a particular stock for the very long term? If the answer is yes, then you can stop reading now. You've accepted the ups and downs that come along with being a long-term investor. Time horizon is one out of three critical objectives to take into account when developing one's overall investor profile; risk tolerance and financial goals are the other two objectives.
My holding period for individual stocks is typically two to five years, sometimes more and sometimes less — and some positions I've been holding in clients' portfolios for over a decade. But as a rule, the single-biggest mistake I see investors make is improper diversification. It's the biggest mistake because it's the cause of substantial, permanent portfolio losses. Six months from now, or a year from now, I could be proven wrong in this particular case. Facebook may still be stuck in the mud and Amazon booming. But while investors can be right on a single stock call, or just get lucky, as a general rule playing the averages is the wiser way to build and maintain wealth.
In the Facebook/Amazon example, you can argue these two stocks are in different sectors, social media and consumer discretion, respectively, but they are both viewed as tech stocks and are both widely held, as can be seen by their disproportionate representation in nearly every large cap stock index, ETF, and mutual fund. By one count, there are more than 100 ETFs with Facebook among their top holdings and more than 230 ETFs with exposure to Facebook. There are roughly the same total number of ETFs with exposure to Amazon.
Top 10 U.S. sector ETFs by performance year-to-date
If you want to diversify your holdings, you need to shift profits from a stock to another sector — such as energy, financial, or health care. Stock investors can only seek diversification among different sectors.
Today, many investors who believe they are diversified are under a false sense of security because so many ETFs and mutual funds are holding the same mega-cap stocks. Add to that the individual stock holdings many investors have in FANG names and the over-concentration can create a risk similar to what we saw with tech stocks before the dotcom bubble burst and financial stocks before the 2008 crash.
Those bubble-bursting-level losses are what got me thinking about this. Maybe you're a baby boomer reading this, or your parents are boomers. I speak with boomer-aged investors every day. They are the generation that was hit hardest by the last two severe stock market drops. Believe me when I say that as a group they are still scarred by those market drops. It's the first thing that come to their minds whenever they see the major market averages plunge; something that's been happening a lot lately.
This fear is an acute form of the boomer anxiety about being able to afford to retire, and I can't understate the risks — they go well beyond investing. We now know that a big, sudden loss of wealth, a negative wealth shock, is associated with a real rise in risk of all-cause mortality, based on research from the Journal of the American Medical Association and conducted by Northwestern Medicine and the University of Michigan. It's long been known that anxiety and stress have the potential to shorten life spans. It's also long been known that part of the job of advising clients is to be a part-time psychologist.
Maybe that last part will grow in scope, but one thing a human advisor can already do today is preventive stress management — in this case, screening a portfolio for stock concentration and lack of diversification. To be absolutely clear, diversification is a method of managing risk, not protecting against losses in a down market. If the bottom does continue to fall out from under tech stocks, having differently correlated sectors to balance out the poor performance does lessen the overall risk.