Everyone loves a tale of rapid market gains, but these headlines often miss the real story, writes Kimberley Short
A temptation many investors succumb to is focusing their attention on sectors that have risen significantly during the last several years or quarters. This is understandable because everyone loves a good story – and specifically, we love a story about gains in the stock market.
This is the case with FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks. These stocks have really delivered most of the gains in the US market over the last year, and the recent weakness in some of these stocks has attracted a lot of attention.
However, we have to be aware that financial headlines often miss the big story, and the attention paid to gains or losses in one sector ultimately amounts to recency bias. Our job is to ensure that we steer clients away from potential hazards caused by this type of bias. Recency bias can cause a mania to set in, and although it can lead to some shortterm profits, it is rife with a history of casualties, particularly among novice investors.
One memorable example of recency bias is the banks that benefited from the US housing bubble that ended in 2007; before that, it was the dot-com mania in 2000. Short-term profits were made by early investors buying in at low prices when the companies had good value, but it became a game of musical chairs when valuations exploded and fear of missing out drove stock prices well above reasonable levels. The losers at the end far outnumbered the early winners.
Knowing when to take profits before the music stops is the hardest part. We refuse to play these games and use a variety of tactics to ensure that our clients keep FAANG stocks and other sectors in proper perspective. Our portfolio management methodology requires that the underlying fundamentals of any stock have to be sound – which eliminates many of the FAANG stocks from consideration.
The discipline of actually taking profits as stock prices increase has gone a long way to smoothing returns. Yes, we have left money on the table, but we would rather be looking at cash in our hands as a stock we sold continues to rise than to be looking at a stock we own crash because we were hoping to squeeze out the last few pennies of profit.
The recent weakness in some of the FAANG stocks is only one factor, but it mirrors the weakness we saw in major US banks in early 2008. Even a 20% fall in price did not make these banks undervalued at the time – it just made them less overvalued, which turned out to be too true when that party ended later in the year. Fundamentals always matter, as does diversifying: buying out-of-favour, unfashionable stocks as a counterbalance.
We are intrigued when investors fall deeper in lust with a company that has romanced us all with futuristic-feeling innovations, such as the promise of drone delivery of shopping purchases and food orders. It becomes easy to then regard the fundamentals of the company as unimportant and to ignore its volatility
At the extreme, many investors no longer look at P/E ratios or dividend yields as a metric for analysis of a company; rather, sentiment and momentum indicators become the decision-making tools. Trying to time those extremes is fraught with danger.
We also recognize that Canadians investing in FAANG stocks face currency risk. Since 2016, we have seen the loonie stay relatively weak against the greenback, but we cannot forget that it was only as far back as 2008 that our dollar was above par. Any spike in inflation, any commodity shortage or any crisis in the capricious US political system could cause our dollar to rise just as the volatile FAANG stocks sell off.
Geographic diversification for Canadians remains a critical component of both risk management and yield realization. Overall, understanding our clients’ objectives for their portfolios is as important as the security selection criteria we use. For some, being weighted in these fast-moving stocks will make sense – as long as the clients, and we, keep in mind that FAANGs can bite.
Kimberley Short is an investment advisor with ShortFinancial who specializes in financial and insurance planning. She is insurance licensed and has successfully completed her CFP designation