Charts of the Month - February

Behaviorally Dangerous Year

Wall Street Journal columnist Jason Zweig wrote in recent years:

“Investors are always searching for good ideas, when what they need are good habits.”

Morningstar conducts an annual study—Mind the Gap—that shows most investors underperform the funds they invest in.

Why do they underperform? Bad habits. Mostly driven by poorly timed purchases and sales of fund shares. Put simply, most investors tend to buy the most at the top and sell the most at the bottom.

Peter Lynch—the former manager of the Fidelity Magellan Fund—returned 29% annually in the decade he managed the fund. One of the great track records of all-time, but by Lynch’s calculations, the average investor in his fund only returned 7%.

The shortfall comes from human behavior, which is why it’s referred to as the behavior gap. This is not a concept many are familiar with. But it’s an area where financial advisors add tremendous value, specifically in their efforts to shrink the gap.

In a new book, Money Simplified, Peter Mallouk—CEO of Creative Planning—details one topic where investors often hurt themselves: excess activity.

Mallouk cites a study that shows investors who look at investment statements monthly have an allocation of about 41% stocks and the rest in bonds. Conversely, investors who looks at statements once per year have about 70% stocks and 30% bonds.  

Investors who look at their statements monthly are generally more defensive—making changes more frequently, and those changes are often detrimental to performance.

Good news? More stocks.

Bad news? Fewer stocks.

Mallouk further added that these groups generally resemble investors that have similar financial goals and risk profiles.

Now, why are these studies relevant? Well, a few behavioral traps are potentially being set in front of us.

One comes in the form of an election year. Politics often bring negativity, and that will likely be true again this year. It’s not uncommon for investors to let political turbulence inform investment decisions.

But it’s better to treat the two like oil and water—they don’t mix!

For example, since 1933, we’ve had 15 presidents (7 republicans and 8 democrats), and the path of least of resistance for stocks has been higher.

Another trap may be the fear of missing out (FOMO) in high-performing areas of the market, particularly technology stocks.

Trends we observed in 2020 appear to be resurfacing.

Technology stocks adjacent to the artificial intelligence (AI) wave are soaring. Nvidia is an obvious example—another one, Super Micro Computer (yes, that’s a real name) is already up nearly 300% this year. Bitcoin is back near all-time highs, and the broader crypto ecosystem's climbing as well, which appears to be reflected in Coinbase stock. There's also been a resurgence at Robinhood.

In short, speculative fervor is making a comeback, and it’s natural to feel like you might be missing the party. Trying to manage the emotions associated with rising prices is a difficult task.

One simple idea to keep in mind: When the score gets added up many years from now, you will find getting to the right long-term investing destination will be driven more by good habits, rather than trying to react to big news items.  

The Elephant in the Room: Nvidia

It’s Nvidia’s world—the rest of us just live in it. That comment is made in jest, but its success is undeniable.

It’s captured the cultural zeitgeist—Google searches is one visual that reflects how dominant they’ve become.

Obviously, stock performance is a major reason for that. And to its credit, that performance has been a function of strong business results. A few people sarcastically mentioned, “Nvidia carried the weight of the market on its shoulders” prior to reporting earnings last month.

According to the market, it delivered. Another $277 billion was tacked onto its market cap, which was the largest single-day market-cap gain in history.

The earnings spark notes read like this:

CEO Jensen Huang shared one interesting note with investors after the results that speaks to the complexity they manage through:

"[One of our graphic processing units has] 35,000 parts. It weighs 70 pounds. These are really complicated things we've built. People call it an AI supercomputer for good reason.”

It’s a fascinating company, but the reality for most investors is that it’s not going to fall inside their circle of competence. It’s difficult to handicap. Technology moves fast, and disruptor can become disrupted rather quickly.

Jeff Bezos often said his competitor’s margin was his opportunity. Well, Nvidia’s competitors—and customers!—feel the same way.  

The Wall Street Journal ran this headline shortly after the earnings announcement.

The competition is coming. And the overwhelming majority of the population will have no idea whether Nvidia can maintain or grow consistently from its current position.

Nvidia designs advanced semiconductors, or “the brain of computers, robots, and self-driving cars,” as its website states. The creation of these semiconductors requires expert lithography, etching, doping, and deposition to create intricate transistor structures at nanometer scales.

How many people truly understand what that means? Very few.

The good news? You don’t have to.

Making every topic under the sun your business is an easy way to fall outside your circle of competence. Signs of that happening are visible.

During the last week of February, there was over $20 billion in options activity in Nvidia’s stock—which was four times the amount of the next largest company.  

There’s also been a recent rise in products designed for the sole purpose of trading Nvidia stock.

But Nvidia is a microcosm of a larger story, which is increasing concentration among a few very large companies.

More than 30 cents of every dollar invested in the S&P 500 now goes to the top 10 companies.

Put simply, the diversification inside the S&P 500 is decreasing. A prudent response for most investors would be to consider increasing diversification. Preparing for a range of outcomes—including one where Nvidia goes down—is likely an exercise that will bear fruit eventually.

Market Myth Busting

Amazon was added to the Dow Jones Industrial Average (Dow) on Feb. 26, joining 29 other blue-chip companies. After gaining 179,000% (not a typo) since going public in 1997, Amazon is finally getting the respect it deserves!

Conventional wisdom might say: When a company is added to a widely followed index, you want to buy the company being included and sell the one that is being removed.

But markets have a better curveball than Nolan Ryan.

Let’s look at a few recent examples.

The Dow removed General Electric (GE) in 2017 and replaced it with Walgreens. At that time, GE had been underperforming, debt was piling up on its balance sheet, and it had churned through two CEOs in short order.

The news was terrible, the stock performance was equally terrible, and it was booted from the Dow.

But after being removed, GE went on to beat Walgreens—the company that replaced it—by over 150% through the end of February.

In August 2020, Exxon Mobil got removed from the Dow and was replaced by Salesforce. Earlier that year, oil futures had gone negative as everybody stayed at home, suffocating demand for the commodity. Exxon’s future looked bleak; it was whistling past the graveyard so to speak. 

Then this happened.

Exxon outperformed Salesforce by nearly 200% after being removed.

To be fair, there are examples where the company being added to the Dow performs better than what it’s replacing. Apple replaced AT&T in March 2015 and meaningfully outperformed AT&T post-event.

But there is a lesson: Whenever the masses agree, it’s often a good idea to pause and think.

“When everybody is thinking alike, somebody is not thinking,” to borrow from George Patton.

When considering what the masses agree on right now, it could be argued there’s deep consensus that:

1. The U.S. is the best global market to invest in.

2. Growth stocks are better than value stocks.

3. Technology is the best sector in the market.

You can’t really argue these ideas based on recent returns.

But what happened recently is not indicative of what may happen in the future.

As Mark Twain said, “It’s what you know for sure that just ain’t so.”