Bull markets are annoying. Not because I hate making money. I like making money. But they’re annoying because the whole time the stock market is going up there is a group of people making excuses for why it’s all irrational. Consider this list of narratives for instance:
- Quantitative Easing manipulated stock prices.
- Low interest rates manipulated stock prices.
- Buybacks are the only market driver.
- Low volume means a crash is imminent.
- High frequency trading will cause a market crash.
- The bull market is only because of a few stocks.
You get the picture. Now, in fairness there’s a shred of truth to each one of these narratives. But the thing is, the stock market is always risky. Yeah, it becomes riskier at certain times than others, but these narratives, in solitude, rarely tell the whole story.
Take that last one for instance. During this bull market we’ve seen acronyms created to symbolize how the bull market is being driven by a few big names. FANG, for instance, is the acronym used for Facebook, Amazon, Netflix and Google. These four stocks make up 35.2% of the Nasdaq 100. That’s a lot and it’s because their market caps have gone bonkers as the stocks have surged. But if you pan out a bit you will see that these stocks are only 10.7% of the S&P 500. Not a small number, but much smaller than 35.2%. Pan out some more and you realize that they’re just 4.3% of the Vanguard Total World Index. Now, that’s not really that much. So, if you’re into diversifying across the global stock market then the FANG stocks aren’t actually that important. On the other hand, if you’re into trying to pick stocks and beat the market then, well, good luck. According to SPIVA you will need it.¹
These kinds of narratives are almost always fallacies of composition where the narrator is using a small part of an aggregate to imply that the aggregate is more dangerous than it really is. Now, don’t get me wrong. As I mentioned in my recent speech in Las Vegas I think there are perfectly rational reasons to be underweight stocks these days (valuations, risk tolerance, etc), but beware of these fallacies of compositions that result in narrow-minded conclusions about the state of the world.
¹ – As I described in my paper “Understanding Modern Portfolio Construction”, this whole concept misses the point in the first place. You can’t really diversify within the stock market. Yes, you can reduce single entity risk, but all of those entities are still going to be risky in the aggregate. That’s just how stocks work. When stocks fall substantially in years like 2008 even the safest industries and stocks will get sucked down with the rest of them. In order to truly diversify the risk of the stock market you need to hold other non-correlated instruments like bonds.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.