Listen, I’m as shocked as you are - but we’ve had a question. Someone out there actually reads this stuff!
A reader asks - “I’ve heard advice before to invest my ISA money into 7 or 8 of the brands that I use the most - Coca Cola, Amazon, Google etc. Is this a good strategy?”
Coming up with a topic to write about every week can be a challenge, and so I am thankful to this individual for giving me a jumping off point this week. Saves a couple of hours of staring at a blank screen and a blinking cursor.
This “buy what you know” approach is very similar to the one espoused by Peter Lynch in One Up On Wall Street.
And it is fairly logical. If you invest in brands and companies that you are a customer of, and value, then they are more likely than not to be good companies. And good companies tend to grow their earnings and create value for shareholders.
There are also behavioural benefits to following this approach. If you understand the company and have a sense of loyalty to the brand, then you may be more able to stay invested through periods when the shares are underperforming.
However, in my opinion the cons of this strategy far outweigh the pros.
First of all, administratively, this approach is a nightmare. Which eight stocks are you going to select in the first place? Are you going to split the money equally across all eight holdings? Are you going to invest future contributions in the same manner? What are you going to do if one stock grows to dominate the portfolio? When do you sell a position?
So many decisions, and decisions are the devil. Each one an opportunity for error.
Having eight names within a portfolio is also too low. It is nowhere near enough of a spread.
This lack of diversification means that if something bad happens to just one of your holdings, it will mean a material hit to the overall portfolio value. And even great companies regularly see their share prices marked down heavily.
For just one example, take Amazon - undoubtedly one of the best companies on the planet. If you invested £1,000 into Amazon’s Initial Public Offering back in 1997, your shares would be worth £1.781 million today.
But in order to receive this return you would have had to sit through regular share price falls of over 50%. You might think that you have the stomach for this, but do you? Do you really?
By adopting a “buy what you know” approach, your portfolio will naturally be skewed towards certain sectors.
If I think about the eight brands that I use the most, they might look a little like this:
Microsoft
Amazon
Google
Nike
Netflix
Coca Cola
Mondelez
Zoom
What do we notice? There is a fair old weighting to tech and consumer spending there.
Not a great set up for a year like we had in 2022, when the energy sector was the only area of the market that did well and tech got panned.
Diversification works for two reasons.
Having a spread reduces your overall risk. We have seen that even the best companies in the world go through periods where their shares do really badly, and when this happens you want the impact on your overall portfolio to be limited.
But diversification also works because it gives you the best chance of being in the winners. Picking the winners in advance is really, really difficult but it is a necessity because overall stock market returns come from the right tail.
What do I mean by this? Well, history shows us that the returns of the overall market tend to come from a narrow band of extreme “winners”.
From 1980 to 2014 for instance, basically all of the S&P 500’s return came from 8% of stocks within the market.
Or, reaching the same conclusion in a different way, from 1926 to 2019 only 4% of US stocks outperformed cash. But the returns from this small subset of winners were so extreme that they drove the overall market forwards.
I will leave it to you to decide whether you have the insight to ensure that your eight picks will include these winners of tomorrow.
The only way to know in advance that we will have exposure to the stocks that provide these extreme returns, is to buy the entire market. While this may seem boring, based on what we have just observed it can be the only logical conclusion. It’s a heck of a lot easier administratively too!
As ever, past performance is no guide to future returns. None of the above is intended to constitute financial advice to any specific individual.
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