Why to look twice when your portfolio is doing well

Summary

Summary of "Why to Look Twice When Your Portfolio is Doing Well"

The Indicator from Planet Money
Host/Author: NPR
Episode Release Date: January 2, 2025
Duration: 10 minutes, 12 seconds

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Introduction: Stellar Performance of U.S. Stocks

The podcast episode begins by highlighting the exceptional performance of American stocks in recent times. Darian Woods notes, “People who had American stocks in their retirement fund or share trading app like Robinhood likely had a good year. Notwithstanding a few bumps in the road recently, it was a very good year indeed” (00:11).

Adrian Ma adds context to this success, stating, “From Microsoft to Micron, US Stocks are on a rocket ship. They're leaving the rest of the world behind” (00:24). This sustained outperformance has persisted since the Great Recession, leading to an “America first” investment strategy where investors focus predominantly on U.S. markets, often neglecting international opportunities.

The "America First" Investment Approach and Its Implications

Dan Villalon from AQR Capital Management is introduced to discuss the implications of this U.S. dominance in the stock market. He comments, “The US Stock market has trounced the rest of the world and so it's really hard to argue why people should be rebalancing back into the countries that have underperformed” (00:46). However, Villalon advocates for a more balanced approach, cautioning against complacency despite the strong U.S. performance.

Understanding the Causes Behind U.S. Stock Market Gains

Darian Woods provides statistical backing by mentioning, “The S&P 500…its value was up 24% in 2024” (02:40). The U.S. companies have doubled their earnings compared to global counterparts since 2010. However, this success is often concentrated in a handful of tech giants, raising concerns about sustainability.

Adrian Ma elaborates, “Those earnings have gone up more than double in the US compared to the rest of the world since 2010” (03:10). Critics argue that these gains might be artificially inflated by factors like U.S. government deficits boosting consumer spending—a temporary phenomenon that cannot sustain long-term growth.

Dan Villalon on the Cost of U.S. Market Dominance

Villalon explains that as the U.S. market continues to outperform, it becomes “more expensive” (03:54). Using Amazon as an example, he states, “At the start of 2024, the share price was around $150. Now towards the end of the year, it was around $230” (03:59). This price surge makes new investments less appealing compared to earlier entry points, suggesting diminished future returns.

The Importance of Diversification

The conversation shifts to the concept of diversification as a key strategy to mitigate risk. Darian Woods emphasizes, “Diversification is one of the first words mentioned [in personal finance]” (05:25). Diversification involves spreading investments across various industries, asset classes, and geographical regions to reduce exposure to any single market's volatility.

Adrian Ma highlights, “investing in a lot of different industries in a lot of different locations” (04:58), explaining that this strategy allows investors to balance the higher rewards of risky investments with the stability of safer ones. Dan Villalon reinforces this by stating, “Diversification is famously…the only free lunch in finance” (06:19), underscoring its value in portfolio management.

Challenges and Psychological Barriers to Diversification

Despite its advantages, diversification poses psychological challenges. Dan Villalon points out the discomfort investors feel when their diversified portfolio doesn't perform spectacularly: “the free lunch…is not easy to consume” (06:25). This is akin to choosing a balanced meal over a bag of chips—nutritious but less immediately gratifying.

Furthermore, Darian Woods discusses the phenomenon of FOMO (Fear of Missing Out), where investors are tempted to concentrate their investments in booming sectors like Bitcoin or Meta stocks instead of maintaining a diversified portfolio. Villalon advises, “You want to kind of get more of the losers and have a little bit less of the winners” (08:45), advocating for regular portfolio maintenance to preserve diversification benefits.

Conclusion: The Wisdom in Diversification Amidst U.S. Market Dominance

The episode concludes with a reinforcement of the importance of diversification. Darian Woods aptly summarizes the dilemma: “Leaving when the party's just getting good can be hard, but Dan says it can be wise to have other options for when things start to get messy” (07:55). Adrian Ma reinforces that while the U.S. market shows remarkable strength, a diversified approach safeguards investors against potential market corrections and ensures long-term portfolio resilience.

Key Takeaways:

• U.S. Market Dominance: The U.S. stock market has significantly outperformed global markets, leading to a prevalent "America first" investment strategy.
• Risks of Overconcentration: Relying solely on U.S. stocks, especially high-performing tech companies, can lead to overvaluation and reduced future returns.
• Diversification as a Strategy: Spreading investments across different industries, asset classes, and regions mitigates risk and stabilizes returns.
• Psychological Barriers: Investors may struggle with the discipline required for diversification, often swayed by the allure of high-performing assets.
• Long-Term Resilience: Maintaining a diversified portfolio is essential for weathering market volatility and ensuring sustainable growth.

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Notable Quotes with Timestamps

• Darian Woods (00:11): “People who had American stocks in their retirement fund or share trading app like Robinhood likely had a good year. Notwithstanding a few bumps in the road recently, it was a very good year indeed.”

• Adrian Ma (00:24): “From Microsoft to Micron, US Stocks are on a rocket ship. They're leaving the rest of the world behind.”

• Dan Villalon (06:19): “Diversification is famously, or maybe infamously called the only free lunch in finance.”

• Adrian Ma (06:53): “Higher risk, higher reward. And that is basically how markets work.”

Transcript

[NPR]

Npr.

[Darian Woods]

People who had American stocks in their retirement fund or share trading app like Robinhood likely had a good year. Notwithstanding a few bumps in the road recently, it was a very good year indeed.

[Adrian Ma]

That's right. From Microsoft to Micron, US Stocks are on a rocket ship. They're leaving the rest of the world behind. And this outperformance has actually been going on since at least the Great Recession. So a lot of people are now taking an America first approach to their investments and forgetting about investing in the rest of the world. Dan Villalon is with AQR Capital Management.

[Dan Villalon]

The US Stock market has trounced the rest of the world and so it's really hard to argue why people should be rebalancing back into the countries that have underperformed.

[Adrian Ma]

Dan, though, is trying his best to make that argument. This is the indicator from Planet Money. I'm Adrian Ma.

[Darian Woods]

And I'm Darian Woods. Today on the show Corporate American Exceptionalism, Dan makes the case for why a stock market hot streak might give investors pause after the break.

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[Darian Woods]

The S&P 500 is the index of 500 big American companies. As of this recording, its value was up 24% in 2024. In fact, on the whole, it's been an incredible last Dec. Decade and a half. There is a global stock index that tracks the value of public companies from all around the world, and that's called the MSCI All Country World Index. And US Shares make up two thirds of that. In other words, US Companies are valued at double the rest of the world's public companies combined in that index.

[Adrian Ma]

And so to understand what this means for investors, we first need to understand what's causing those big gains in those company valuations. Looking at the earnings of US companies, on average, they have made out handsomely. Those earnings have gone up more than double in the US compared to the rest of the world since 2010. Now, critics will say a lot of that is concentrated in just a handful of tech companies. Also, they point out that the US Government deficits might be juicing the economy temporarily. So, for example, consumers might be buying more products from Apple or Walmart. But that can't last.

[Darian Woods]

Regardless how much money these companies are making doesn't tell the full picture. Dan Villalon is a principal at AQR Capital Management.

[Dan Villalon]

As the US has outperformed, it has also become more expensive.

[Adrian Ma]

So take Amazon, for example. At the start of 2024, the share price was around $150. Now towards the end of the year, it was around $230. Amazon may be extremely profitable over the next 10 years, but a lot of people already think that. So when someone invests in Amazon now with that high share price, it's not as good a deal as it used to be.

[Dan Villalon]

I think, you know, finance, investing, it's not like physics, it's not like gravity. It's not true that what goes up must necessarily come down. But that said, there tends to be a bit of a headwind to assets that are very expensive.

[Darian Woods]

Maybe an investor truly believes that American companies and people and institutions and resources are the very best in the world. That doesn't necessarily mean that they should invest in only the U.S. what matters is whether that optimism is already priced in or not.

[Adrian Ma]

Yeah, that requires some pretty deep analysis and a real attention to markets that, frankly, most everyday people don't have time for. And that's where one investing magic trick comes in. Diversification. Basically, investing in a lot of different industries in a lot of different locations.

[Dan Villalon]

Not having all of your eggs in one basket is a great way to build a portfolio that's likely to hold up better than the ones dominated by one thing.

[Darian Woods]

Whenever personal finance is discussed, diversification is one of the first words mentioned. And it's worth reminding ourselves exactly what it means and that it can be a challenging principle to follow.

[Adrian Ma]

Yeah, so, for instance, a lot of people are heavily invested in the house they own. And that might be by necessity, but that's the opposite of diversification. One asset class, housing in one neighborhood. A diversified portfolio might mean being less focused on owning a house, but having more of a spread of investments in other asset types. You know, stocks and bonds, maybe a little gold or precious metals. Basically all of them.

[Darian Woods]

Diversification also means investing in lots of different industries, plus lots of countries. Maybe one year the US Goes into recession, but Japan doesn't. Diversifying which countries people invest in would protect against losing a chunk of their savings.

[Dan Villalon]

Diversification is famously, or maybe infamously called the only free lunch in finance.

[Adrian Ma]

And the free lunch is this. You've heard the expression, higher risk, higher reward. And that is basically how markets work. Riskier industries, riskier countries, more chances to lose, but possibly a better return on investment when things go well. Now, if someone is diversified, they can still get some of those higher rewards while being insured. So if one company fails, another might do well. So it's a low risk, high ish reward.

[Dan Villalon]

But there is a cost, psychologically, mentally, is the lunch may be free, but it's not easy to consume.

[Adrian Ma]

I mean, yeah, it's like you could have a perfectly balanced, healthy lunch, but is it really as fun as just like housing an entire bag of chips?

[Darian Woods]

Yeah, bag of chips is pretty easy to wolf down. And so what he's saying is that it's not easy to consume because these investors will be missing out on the really, really high gains that are possible when somebody goes all in on one or two companies.

[Dan Villalon]

So I've got three kids. I would say there's probably a 30% chance that one of them is misbehaving on any given day. So the question is, what's the likelihood that at least one of my three is misbehaving? Well, those odds are about 66%. And that's sort of. That's the flip side. That's the other side of the coin of diversification. You should expect that something in the portfolio is not doing well when you look at it, but it doesn't mean that the portfolio is impaired.

[Darian Woods]

When an investor has a diversified portfolio, there can be this kind of fomo. Bitcoin just went to the moon. Meta stocks are up. What if they'd only invested in those things? Well, Dan says those thoughts can tempt investors away from diversification. And that brings us back to why it's particularly tempting now to stick with only US stocks.

[Dan Villalon]

The US has become pricey, and other markets, you know, even though they are less loved, may be offering a better deal over the next five to 10 years. I would never say, you know, to get out of a market altogether, but I would use that as an encouragement to get folks to diversify a little better across all.

[Adrian Ma]

In some ways, if someone's been heavily investing in US Tech stocks recently, it must feel like they've stumbled upon a gold mine. So why would they pack up and explore elsewhere?

[Dan Villalon]

I think people are a little asymmetrical when it comes to this. I think most people, they see bad and they say I've got to change something, but when they see too good, they don't also kind of decide to change something. You want to kind of get more of the losers and have a little bit less of the winners. Because if you don't do that, if you don't have that kind of regular maintenance of your portfolio, you could end up missing some of that free lunch, some of that, some of the value of diversification.

[Darian Woods]

Leaving when the party's just getting good can be hard, but Dan says it can be wise to have other options for when things start to get messy.

[Adrian Ma]

This episode of the Indicator was produced by Cooper Katz McKim with engineering by Neil Tibolt. It was fact checked by Sierra Juarez Cake and Cannon edits the show and the indicators of production of npr.

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