By Tim Courtney, Chief Investment Officer
A recent story in MarketWatch explored a challenge investors face today following the last decade of market behavior: Is the diversified portfolio dead? With AI “superstocks” creating an increasingly concentrated equity market, more investors are questioning the merits of this long-standing investment principle.1 History has shown that diversification puts investors in a much better position for successful long-term outcomes than concentration.2 Yet the question persists: Is this time different?
100 years’ worth of market data on U.S. companies is available for research and analysis. We can’t know the future, but the data provides insight as to how the market tends to behave. An uncontroversial principle that comes from this data is that stock returns are related to company profits plus the growth of those profits over time. This idea makes sense, and earnings and growth are fundamental measures that investors consider before buying shares.3
Based on this principle, an investor may think that they will invest only in those companies with the highest profits/margins and the fastest growth. But it is not that simple, as the data also indicates that higher profit/margin and faster-growing companies tend to be much more highly priced. It makes sense that investors would be willing to pay more to own these companies, but it turns out that the highest-priced companies tend to underperform the whole market over time.4
This gives us something to think about. Price is an important consideration, maybe the most important consideration, when deciding whether to buy a company. No doubt some of the AI-related companies today are generating high profits/margins and are growing quickly. But the market knows this and has priced those shares much higher than those of other companies.
In this way market pricing is like a point spread in sports. A talented team must win by a certain number of points over a lower-caliber team before one can profit by betting on the better team. Similarly, a high-priced company usually must generate profits and growth in excess of what the market already expects if it is to outperform. That is no small feat today as expectations for AI profits and growth are as optimistic as they have ever been, and therefore prices are as high as they have ever been.
Circling back to the issue of concentration versus diversification, some investors today have embraced concentration in high profit/growth companies as a prudent strategy. History shows though that we also must account for prices, and that if companies do not meet the expectations investors have placed on them, shares will likely underperform— possibly enormously. History and the data provide no blueprint for successfully concentrating in a handful of high-priced, fast-growing names.
Rather, history shows that investors should be mindful of the prices they pay for assets and that the more concentrated a portfolio is, the more the investor is betting that those companies will outperform the already high expectations placed on them. We expect that AI will become a tool that will benefit many people and companies just as the internet did in 2000. But then, as now, we expect a diversified strategy to be the prudent strategy as the tool is adopted and integrated into the economy.
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