Go Big or Go Home

By: Michael Foster CFA, CFP®

‍

If you don’t follow the US stock market closely, you probably haven’t noticed anything strange in this part of your portfolio so far in 2023. It’s been up and down, but the return of the S&P 500 is about 13% (through September). This is higher than the long-term average, but not so far above that you’re likely to be doing cartwheels in your living room. Instead, you probably have noticed that the weather has turned cooler, the leaves are changing, football season is in full swing, and pumpkin patch pictures are making their annual return on your social media feeds. Life is good!

‍

If you do follow the US stock market closely, you may have a different perception. Despite being positive overall, US market returns are being driven by a handful of companies being dubbed “The Magnificent 7”.  These companies, Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla, have seen very high levels of returns this year. As of October 5^th, these companies have returned about 92% on average per CNBC. They also happen to be the largest 7 companies in the S&P 500, driving a lot of the positive return investors have seen this year to this point. 

‍

So, should we only buy the biggest companies? Aren’t they big for a reason? Is the Apple in my portfolio better than the apple I just picked at the recently opened seasonal orchard? My answers would be no, yes, and it depends on what variety (team Honeycrisp) to those questions.

‍

There has to be a lot of growth and/or acquisition in order to become one of the biggest companies. The chart below shows how companies joining the 10 largest in the US have performed versus the overall US market before and after joining the top 10. As you can see, these companies have impressive returns leading up to the top. The average annualized outperformance of these stocks is almost 12% higher than the market at large in the decade prior to becoming a top 10 company. The number jumps to almost 27% in the 3 years leading up to top 10 status. 

Source: Dimensional Fund Advisors

‍

What happens next isn’t as exciting. Once a company has joined the top 10 largest, they tend to underperform versus the market on average over the next 3, 5, and 10 years. Those large levels of outperformance tend to slow down pretty dramatically. 

‍

This isn’t to say we don’t or shouldn’t hold these largest companies, quite the opposite! Instead, we just choose to own them in low-cost investments that also happen to own hundreds or thousands of other companies. Diversification reduces our exposure and risk to any single or handful of companies. We believe in investing in capital markets broadly over time in order to meet the goals of your financial plan.