MarketWatch recently published an article on how the S&P 500’s SPX return of 30% in 2019 was a result of only two key stocks: Apple AAPL, and Microsoft MSFT. If that’s the case, then is it really all that hard to diversify your investment portfolio? Why do you need to diversify in the first place?
The short answer is: yes, it’s definitely difficult, and any investor or financial advisor who says otherwise is most likely inexperienced. Meanwhile, diversification is key to successful investment in the stock market because you minimize risk while on the search for that whale of an investment that’ll get you a sizable return.
So where do index funds come in? Read on for the long answer.
Understanding the impact of stocks on the market at large
When playing the stock market, you may feel overwhelmed by the crazy amount of information available to you. And you may have heard of this before from fellow investors: ‘it’s about quality, not quantity’. Well what does that mean? According to research from the Journal of Financial Economics, a whole lot.
Let’s again look at the impact of a small number of stocks on the economy at large. From 1926 till today, the U.S. stock market’s entire growth can be attributed to 4% of its stocks, with the rest hardly doing any better than short-term Treasury bills. In fact, the mode (data point that appears most frequently) shows a loss of 100% in most stock returns. Therefore, at least most of the time, investing in stocks will result in a 100% loss.
Old wisdom once dictated that you need to invest in at least 20 stocks to have considered your portfolio diversified. We now know this is wrong – most recently because of study in December 2019, which reproduced a 1990 study conducted by University of Main’s professor John K. Ford. They wanted to see if those teachings of old still held up.
It turns out that 10% of the portfolios lagged the market by 10% or more, 26% lagged by at least 5%, and 40% lagged by at least 2%. Not the greatest outcome.
Ford reports, “An investor willing to accept only a 10% chance of missing the market by 5% or more needs to diversify across 80 stocks…”, which is a far cry from the original 20 of days past. He continues, “If the investor wants [no more than] a 30% chance of missing the market by only 2%, [they] must diversify among at least 90 stocks.”
This is a result of there being only a few key profitable companies in the stock market, dominated by the likes of Apple and Microsoft. And the only chance you’ve got to own a share in these company’s profits is by diversifying, diversifying, and diversifying your portfolio as much as you can.
Will index funds diversify your portfolio?
A recent trend that many investors have been taking to is investment through index funds. It makes sense: index funds are a type of mutual fund whose holdings match or track a market index, like the aforementioned S&P 500, Nasdaq, or the Dow Jones Industrial Average. If your goal is diversifying, index funds could be your best bet. But before you go all in, remember that even different market indices have varying levels of diversity.
Take, for example, how the 11 sectors within the S&P 500 are weighted. Even though only the top 2 holdings in each category are being weighted, their effect is extremely significant. What this shows us is only a few stocks really contribute a noteworthy amount to the S&P 500 as a whole, so the chances of you getting a good return from an index fund based on them is lower.
Though some trends may seem impervious to time, enduring over decades and decades of economic change and development, a great investor has to consider all the factors, and that includes challenging the ideals and norms of past. After all, uncertainty is the only certainty.
The good news is, you’ll learn all this and more on the journey to successfully planning your investment portfolio with 10X Wealth Management. Contact us today for any inquiries, and get the help of industry-leading professionals who will guide you on the path to a secure financial future.