2021 has been a historic year for stocks. Through the first four months of the new year, the S&P 500 is already up 12% with investor optimism showing no signs of slowing down. In the past 12 months popular companies such as Visa, Facebook, and Tesla have seen their stock price grow 23%, 46%, and 306% respectively. During such a bull-market stretch it can become tempting for investors to put their money into huge, well-known companies that have shown recent rapid growth. It would be hard to blame anyone for wanting to be a part of Tesla’s unprecedented rise given their numbers during the past year. However, solely investing in the “biggest” stocks has not proven to be a reliable strategy for future growth historically.
Take the ten biggest companies in the US for example. When looking at the chart below it quickly becomes obvious that the best time to invest in a company, and normally the only time it will outperform the rest of the market, is in the lead up to it becoming a top ten company. A classic example of this phenomenon is Intel. In the decade leading up to Intel’s debut as one of the ten biggest companies in the country it averaged a 29% outperformance of the market annually. In the decade that followed this rise, Intel underperformed the market by around 6% annually.
There is some logic surrounding this pattern. A company’s stock price is the market’s current valuation of the firm, with both current data and future expectations for growth built into the price. Any company that is heading towards the top ten list in market cap tends to have both an innovative product and strong financial data to support their growing valuation. It is almost impossible to keep this innovation and financial strength going indefinitely, which eventually leads to a plateau in performance and therefore a stagnant price compared to the market as a whole with new, innovative companies restarting the cycle.
It is one thing to understand the pattern of outperformance while a company is growing followed by underperformance after reaching a certain size, but it is another thing altogether to try and select the companies that will experience this cycle. Study after study show that nearly no one can consistently pick stocks that outperform the market, and it’s difficult to differentiate the few that can until after they retire. The way around this problem for the average investor is to strategically diversify their portfolio. Through diversifying your portfolio into different kinds and sizes of companies, you can maximize potential growth at a minimal level of risk. For more information on how we can help you invest to achieve your financial goals, visit our website www.kdminvest.com.