By Brad Thomas, Wide Moat Research, Trades Of The Day, 2024-06-26
This caught my eye…
From Yahoo Finance:
Nvidia's Surge Reveals a Pitfall of Passive Investing
Nvidia (NVDA) notched its 43rd record closing high on Tuesday, bringing its 2024 return close to 175%.
So far, so true.
Nvidia is a significant company with powerful forces pushing its share price ever higher. I'm not disputing that, and Yahoo has every reason to highlight its progress. It is, after all, news.
Then things take a strange turn:
Unfortunately, passive investors relying on mutual funds and ETFs as investment vehicles haven't been able to participate in all of these gains.
[…]The heart of passive investing is premised on managing risk through diversification. In theory, a diversified tech index is “safer” than one in which three stocks dominate the index.
Then, we get to the mind-bogglingly pointless:
But over the last four years, Apple (AAPL), Microsoft (MSFT), and Nvidia have so thoroughly trounced the rest of the market that ETFs are bumping up against rules and regulations that limit the weight of individual stocks in funds.
In theory, each of these three behemoths should be weighted at just over 20% of the XLK fund — if it matched the benchmark. However, many investors (including this author) were recently surprised to learn that Nvidia only comprises 5.9% of the ETF.
[…]All of this stems from Great Depression-era investor protection laws, which require that indexes limit the concentration of individual stocks to earn the label “diversified.”
The author concludes the essay by saying that all this poses a “risk” of missing out on some gains because of the rules governing the funds.
First, it's a little odd to think of not making more money as a “risk.” It's also odd that there are quotation marks around “safer,” as if implying that the description isn't warranted.
I'll let you be the judge of what that says about our current environment.
But the overall insinuation seems to be that most investors don't have enough exposure to the big names. Heaven forbid!
Never mind that theS&P 500 ETF (SPY) – an ETF that allegedly tracks the S&P 500 and is the most widely followed passive fund – already weighs 31% towards just six stocks. Never mind that if an investor wanted more exposure to the bellwethers, they could just… buy them directly.
Never mind all that.
The problem, it would seem, with diversification is… that it's too diversified!
Which, obviously, comes with the territory. When you choose a path of lessened risk, you're bound to curtail your potential rewards as well. This is, in fact, the very definition of the word “safer.”
If you ask me, the writer appears starstruck by Nvidia's more than 900% gain since 2020. He's encouraging investors to put more of their money into a single stock, essentially putting it on a pedestal.
And that's a place no single asset or category of asset should ever be. Not if investors want to avoid disaster.
Believe me, I would know…
I'll Never Forget This Investment Lesson Learned
I know something about the difference between diversification and disaster.
Some of you already know my story and what led me to my current position as an investment analyst. But for those of you who don't, let me break it down…
I was an active and enthusiastic participant in the events that led up to the market crash of 2008.
As a commercial real estate developer, I happily overbuilt shopping centers and single-tenant properties wherever I was properly paid to. And then I overbuilt even more for myself, renting out the available spaces to an array of businesses.
I was making bank, as the kids would say, and I had every reason to think that happy situation would never change.
You see, real estate just kept going up in price. It was booming back then, with demand only increasing and valuations only rising.
Moreover, I was good at what I did. I researched land before I built on it. I studied my clients and tenants before I signed them on. I crunched the numbers, and I worked hard, all of which paid off.
Diversification? Who needs it? I was all in.
I had a good thing going for over two decades… right up until the housing bubble burst (thanks in part to that overbuilding I mentioned).
Then I lost everything…
And that happened because almost all my investments were in commercial real estate. I promise you, during those dark days I wish I had been more diversified.
My family and I went through living hell – all because I got starstruck with a single asset category, putting it up on a pedestal.
It took me years to pull us out of that monetary hole. Hardly a pleasant experience and one I never want to repeat.
But it taught me a life lesson I'll never forget. And you shouldn't either.
Diversification matters. And no single asset is ever truly too big or popular or long-standing to fail.
Don't Kid Yourself: It's Never a Sure Thing
I'm not trying to pick on Nvidia here. It's had a stellar run.
But in the end, I don't care how stellar it seems. I don't even care how stellar it is. As an investor, you never want to be too heavily exposed to one asset or investment.
There are no guarantees in life, and you don't have a crystal ball. You have to plan accordingly, spreading your money out across numerous investments across multiple categories.
You don't have to own mutual funds or ETFs if you don't want to. In fact, many of them are rarely what they seem and worth avoiding. And you can own actual shares of Nvidia or whatever other “it” stock you'd like.
But you don't want to own it alone.
You don't even want to put half your money into a single asset. You probably don't even want to put 10% or 5% down.
Otherwise, you risk finding yourself parked at a local strip mall you once owned with your head in your hands, wondering where it all went wrong and how in the world you were ever going to make it right.
Sir John Templeton – who Money magazine called “arguably the greatest global stock picker of the [20th] century – once said that “the only investors who shouldn't diversify are those who are right 100% of the time.”
You might want to fight me and Templeton on this, saying that you have a hot tip from a reliable source… or that you've crunched the numbers… or that this is a sure thing… or that this time it's different.
So, why wouldn't you go “all in”?
I've seen that type of thinking too much.
I've seen it with crypto. With NFTs. With “meme stocks.” And yes, I lived it with commercial real estate.
It never ends well. And I do mean never.
Diversification may mean you limit your upside. But you also limit your risk. And – when done correctly – you eliminate the ultimate risk of being “wiped out.”
If not making more money from diversification is the biggest risk, sign me up any day.
Regards,
Brad Thomas
Editor, Intelligent Income Daily
Source: Wide Moat Research
