How Do You Get In on the Next Amazon? You Diversify

If you’ve been reading my blogs long enough, you know that my mantra is diversification. If you own everything that the market offers, then you don’t have to worry about picking the next big thing. You’ll already own the next big thing! A recent article in The Wall Street Journal underscores my point. In “Amazon’s 49,000% Gain: The Most ‘Super’ of ‘Superstocks’ Since 1926,” writer Jason Zweig discusses the near futility of trying to hunt down and invest in superstocks.

Here are some eye-opening facts to illustrate why diversification is important:

  • Between 1926 and 2015, just 30 companies out of 25,782 accounted for one-third of the cumulative wealth generated by the U.S. stock market.
  • In that same period, just 0.33% (not even 1%!) of companies in the U.S. stock market accounted for half of the wealth generated for investors.
  • In that same period, fewer than 1.1% of the stocks that existed created three-quarters of the stock market’s cumulative dollar gains, as measured relative to the returns on cash.

It’s obvious that searching for the next superstock like Amazon is like hunting for a needle in the haystack. Actually, finding the needle might be easier! And that is because, as Mr. Zweig points out, the superness of superstocks isn’t immediately apparent. It takes time for these companies to reach their potential, and they often do abysmally before they go big. Amazon, for example, lost 95% between 1999 and 2001.

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Only Psychics Know the Winners

The time lag is why I counsel my clients on the benefits of long-term thinking. It is only through the long term that they can expect to hold winners like Amazon.

However—and this is a big however—they are less likely to hold an Amazon if they fail to diversify their portfolio. As the Wall Street Journal article points out, it’s not enough to own 15 to 30 stocks, which amounts to traditional advice on diversification. “Superstocks are so scarce that you need to hold hundreds, even thousands, of companies to be near-certain of matching the market’s return,” Zweig writes.

If you don’t own the high performers, your portfolio is probably going to underperform. But unless you’re psychic, you’re going to have a hard time picking the winners.

Let’s take a look at the S&P 500 top 10 performers in 1980:

  • Global Marine
  • Tandy Corp.
  • M/A-Com Inc.
  • Reading & Bates
  • Wang Labs
  • U.S. Home
  • Houston Oil & Minerals
  • SEDCO Inc.
  • Burlington Northern
  • Fluor Corp.

How many of those companies do you remember? Ten years later, the top 10 were:

  • Home Depot
  • NCR Corp.
  • Nike Inc.
  • Alberto-Culver
  • Service Corp. International
  • IMCERA Group
  • Beverly Enterprises
  • Jude Medical
  • Compaq Computer
  • Biomet Inc.

None of the companies that were top performers in 1980 made the list in 1990.

In 2000:

  • Dynegy Inc.
  • Reebok International
  • EOG Resources
  • HealthSouth Corp.
  • Calpine Corp.
  • Kinder Morgan
  • Power-One
  • PerkinElmer Inc.
  • Coastal Corp.
  • ALZA Corp.

Again, no overlap of high performers. In 2010:

  • Netflix Inc.
  • F5 Networks
  • Cummins Inc.
  • American Intl. Group
  • Zions Bancorp
  • Huntington Bancshares
  • Akamai Technologies
  • Whole Foods Market
  • Inc.
  • Qwest Communications Intl.

And finally, 2016—our most recent year:

  • NVIDIA Corp.
  • ONEOK Inc.
  • Freeport McMoRan Copper & Gold
  • Newmont Mining
  • Applied Materials
  • Quanta Services
  • Spectra Energy
  • Comerica Inc.
  • Martin Marietta Materials
  • Halliburton Co.

Picking the winners from year to year is nigh impossible, yet not owning the top 10 stocks represents an opportunity cost. It’s a mathematical fact:

  • The best-performing stocks can go up over 100% or more in any given year (think Amazon).
  • The worst-performing stocks can only go down 100%.
  • Therefore, a few stocks going up more than 100% can outweigh those that go down 75% or more.

Go Broad to Keep Up

This is why I recommend that investors own index funds that own all the companies, such as the Vanguard Total Stock Market Index Fund. Yes, there will always be companies that hit hard times and whose stocks fall 80 or 90%. But by diversifying your portfolio, you can more easily absorb those losses. Meanwhile, you will also likely own the one or two companies whose stocks skyrocket in any given year.

And you want to own those high achievers. Amazon’s stock price is in the quadruple digits right now. If an investor doesn’t own it, the chances of their portfolio keeping up with the broader market average is slim.

So back to my mantra: Diversify. Invest in a total stock market index fund. Own as much as you can so you have the opportunity to achieve the returns you need to keep up with the market and meet your financial goals.