With the end of the second quarter, it’s easy to forget that in 2022 many investors were gripped with the fear of staying invested in risk assets as interest rates rose and equity returns were taking a beating. Now, with so much excitement around Artificial Intelligence (AI) and the Magnificent 7, that “fear of being in” has quickly morphed into FOMO (fear of missing out) now that stocks have come roaring back. For some, this FOMO is even more acute when certain areas of the market are performing far better than others. We simply wouldn’t be human if we didn’t at least ask the question: “Why aren’t I chasing the biggest names in the market?” Afterall, larger stocks have outperformed smaller stocks over the past 5 years[i]:
However, this chart doesn’t tell us the full story. The figures here represent trailing returns for the current biggest stocks in the market, not necessarily the biggest stocks five years ago. As a matter of fact, some of the big stocks of today were smaller five years ago and some of the smaller stocks today were bigger five years ago.
Take Nvidia, for example, which recently overtook Microsoft as the most valuable stock in the World.[ii] Five years ago, Nvidia was outside the top 60 stocks in the S&P 500. Three years ago, it had just barely cracked the top 10 list of names. When we look at returns by decile using the size of companies five years ago as the starting point, the story becomes a bit more interesting:
However, this chart doesn’t tell us the full story. The figures here represent trailing returns for the current biggest stocks in the market, not necessarily the biggest stocks five years ago. As a matter of fact, some of the big stocks of today were smaller five years ago and some of the smaller stocks today were bigger five years ago.
Take Nvidia, for example, which recently overtook Microsoft as the most valuable stock in the World.[ii] Five years ago, Nvidia was outside the top 60 stocks in the S&P 500. Three years ago, it had just barely cracked the top 10 list of names. When we look at returns by decile using the size of companies five years ago as the starting point, the story becomes a bit more interesting:
Many prudent investors would acknowledge that allocating the lion’s share of their portfolio to Nvidia alone, or even a small handful of technology stocks, would subject their portfolios to considerable volatility while simultaneously putting their long-term financial well-being at risk. However, given the recent performance of a selection of US Large Cap names, some may wonder if holding a basket of only US stocks, such as the S&P500, would lead to outperformance vs. a globally diversified portfolio tilted toward small-cap, value, and relative profitability stocks.
The following chart illustrates the 10 year rolling returns for the DFA Global Core Equity Index, a reasonable proxy for the equity allocation in our managed portfolios, versus the S&P500[iii]:
Visually, the chart above illustrates one of the primary benefits of global diversification, the reduction of portfolio volatility. It’s clear the DFA Global Core Equity Index (dark blue line) has fewer extreme peaks and valleys relative to the S&P500 Index (light blue line). That said, given each index has episodic periods of outperformance, it’s not immediately clear whether global diversification and reduced volatility lead to better outcomes long-term.
The subsequent chart illustrates how $1 would have grown over the same period (1975 to 2023) within each index[iv]:
Even on the heels of an impressive 5-year run for the S&P500 to close 2023, remaining invested in a globally diversified portfolio delivered greater growth of wealth vs. the S&P 500. Specifically, $1 invested from 1975 thru 2023 would have grown to $308 in the DFA Global Core Equity Index vs. $273 in the S&P 500. In addition to the reduced volatility benefits, that’s nearly 13% more wealth from holding a globally diversified portfolio as compared to the S&P500 alone.
The first half of 2024 has rewarded our clients with realized returns outpacing expected returns year-to-date. Looking ahead, expected returns remain higher than they’ve been in recent history thanks to the current interest rate environment, not in spite of it. While the choppy markets of 2022 challenged some investor’s discipline, those who have stayed the course are reaping the benefits in the form of higher expected returns and higher future sustainable spending expectations. A true win-win.
As long-term investors, it’s important to know what we own and why we own it. Diversification is a feature of prudent investment management, not a bug, that helps you avoid tail risk events. For better or worse, those tails exist on both ends of the return spectrum. To put it another way, diversification can leave you equal parts appreciative, when the “fear of being in” is at the forefront, and remorseful when FOMO hits.
[i] Data via Ycharts and https://awealthofcommonsense.com/2024/06/chasing-the-biggest-stocks/
[ii] https://finance.yahoo.com/news/nvidia-overtakes-microsoft-as-most-valuable-stock-in-the-world-172859451.html
[iii] DFA Returns Web
[iv] DFA Returns Web Reports
Neither asset allocation nor diversification guarantee against loss. They are methods used to manage risk.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any funds or stocks in particular, nor should it be construed as a recommendation to purchase or sell a security. Past performance is no guarantee of future results. Investments will fluctuate and when redeemed may be worth more or less than when originally invested.