FANG-tasy Vs. Reality

After blasting steadily higher since the beginning of the year, tech stocks just suffered a setback.

The Nasdaq — which hit an all-time high at the tail end of last week — dropped over 3% by Monday morning. It was the exchange’s worst two-day losing streak of 2017.

What was driving the sudden dip?

Investors are beginning to fear that top tech stocks are overvalued. Namely the FANG companies — Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX) and Google (NASDAQ:GOOGL).

As a result, buying interest shifted to different sectors, like energy and financials.

Now, the trend quickly reversed course. Tech stocks once again ratcheted higher this week.

That shouldn’t be surprising to Wall Street Daily readers. We’ve been providing regular coverage of the ongoing bull market for tech.

With 73% of technology stocks beating analyst estimates for earnings last quarter, we should only see more momentum in the coming weeks and months. Especially when you consider that capital is flooding into tech stocks at the fastest pace in 15 years.

But that doesn’t mean you should go all in on tech.

The recent volatility should act as reality check — underscoring the importance of diversifying your portfolio.

So I asked senior analyst Martin Hutchinson to provide a quick rundown on the best way to approach diversification.

His full analysis is below.

Question: Martin, you’ve agreed to help us compile a library of the most important investment catalysts on Earth. I’m talking about baseline concepts that every investor should know.

Today we’ll be discussing how to properly construct a portfolio.

Let’s jump right in, Martin. What’s the first thing any investor needs to know?

Martin Hutchinson: The big question for investors is how to allocate money between sectors within your stock portfolio — and then how to allocate money between stocks against bonds and other assets.

Modern research suggests that how you allocate your portfolio is more important than what stocks you pick.

The efficient market hypothesis says that the expected return on most assets is the same, adjusted for their risk. You can underperform — what they call the efficient frontier — but you can’t outperform it.

Question: Now, is that something you agree with, Martin?

Martin Hutchinson: I disagree on the margins. I think you can pick stocks with superior returns if you’re intelligent and careful.

I also think that asset allocation can be overdone. I think most people overallocate to bonds.

Question: Got it. Continue, please.

Martin Hutchinson: In any case, you shouldn’t bet your retirement on your ability to pick good stocks. Keep perhaps 80% of your assets in a diversified portfolio and pick stocks with the other 20%.

Question: I think I get the gist of what you’re saying here.

Before we dive into the nuts and bolts of allocating, I think you’re saying we do have an ability to pick a superior stock. But we shouldn’t just haphazardly, randomly just pick them. There should be some method to our madness.

Does that sound accurate?

Martin Hutchinson: Yes, that’s absolutely accurate.

I think we have the ability to pick a particular stock, but you’ve got to look at the overall structure of your portfolio, as well. And you shouldn’t bet the ranch on your ability to pick stocks.

Question: Suppose I have a tech bias and I feel like I’ve got a good edge on the tech market. If I’m not careful, before long I’m going to have a very tech-heavy portfolio.

Can we get into allocation and how to construct a portfolio and prevent against this — and also why that might be bad having all the same stocks in the same sector?

Martin Hutchinson: Firstly, let’s talk about allocating between asset classes, because you’ve got to look at your portfolio as all the assets you own.

Stocks, you should have a large portion when you’re young — and less so as you get older — because they’re volatile. If you’re drawing down your portfolio to live off, you need something that’s not going to zoom up and down too much.

Most people recommend 40–50% of bonds at 65, the normal retirement age.

I think that’s too high. Returns on bonds are low, and they don’t protect against inflation. So I think they’re a pretty unattractive asset. I would have certainly less than 40% or 50% in them.

Cash is beginning to give a decent yield again. With stocks high by historical standards, maybe you would have more cash than usual.

Real estate tends to have a lousy cash flow. You don’t want to own more home than you can afford. In other words, don’t get yourself too large a mortgage, because you’re liable to get yourself in trouble. Possibly, if you want more real estate or think you should have some more in the portfolio, own some rental real estate if you don’t mind the time involved in managing it. That can be a useful protection against inflation and throw off income if you know what you’re doing with it.

Then finally, gold. Don’t forget those politicians in the Fed are always too expansionary. Gold’s the best protection against this, but don’t have more than 10% or 15% of your portfolio in gold. In the overall gold category, include some silver and include some mining companies.

Question: Great, Hutch. That’s a 30,000-foot view of a properly constructed portfolio. Looks like it has five different asset classes, if we’re going to count cash as an asset class, which I believe we will.

If we tighten the lens within that stock allocation, how should we construct that part of our portfolio, Hutch?

Martin Hutchinson: I think there are some general rules on this.

Bias toward income stocks when you’re retired — and by income stocks, I mean paying ones that are paying 3% dividends or more. Don’t assume the stock repurchases are the same as dividends, because you don’t get them in cash. You want stocks that actually pay out physical dividends.

Don’t overconcentrate in tech if you have a bias toward tech.

Alternatively, lots of us have biases toward mines or energy. Don’t overconcentrate in those, either. You need some of both, and you need an overall portfolio structure that’s not too different from the S&P 500.

Try to spread yourself among sectors approximately on the S&P 500, by all means, with a bit more tech or a bit more mines and energy, but don’t be wholly overweighted.

Know when you’re overweight or underweight a sector, and make sure you’re happy with this. In other words, do compare the portfolio with the S&P 500 and say, “Hmm, I’ve got a lot of retail in there,” for example — and adjust accordingly.

Question: Now, Hutch, you’ve spoken at sold-out investment conferences around the world and talked to a lot of investors.

What’s the biggest mistake you see out there that folks are making?

Martin Hutchinson: I think they tend to overconcentrate in what they’re fond of or what’s fashionable.

That can be tech at the moment, and maybe to some extent U.S. stocks — which have had a hell of a good run.

Diversifying across international markets and across sectors is very important.

Asset allocation isn’t the only part of the game. Even though it’s important, you should do it as a basic skill.

Still, by all means, recognize your ability to pick stocks on top of that.

Question: The combination of superior stock picking along with a properly constructed portfolio really puts us ahead of the game.

Martin Hutchinson: I think that’s right. I think that’s the ideal, yes.

Question: Hutch, thanks for your time.

Martin Hutchinson: Great to be with you.

Question: This is Wall Street Daily signing off.

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