We've certainly had a bumpy start to the year. While the S&P 500 has made great gains following 2022, markets have been volatile. But this volatility is par for the course when investing in shares and patience has rewarded long-term investors.
With a number of bank collapses, starting with Silicon Valley Bank and now First Republic Bank, it is natural to be concerned about markets. However, we must separate the stock market from stocks in the market. Below is a short article from Dimensional founder David Booth discussing how diversification avoids the risk of individual shares.
Before the article, I have included a link to Dimensional's Fund Landscape report. Similar to Standard & Poor's Index Vs Active (SPIVA), this compares the performance of active managers to the market index. The 2023 report brings no suprises, with the majority of active managers failing to beat their benchmarks over 10, 15 and 20 year periods.
Fund Landscape - How Mutual Funds Have Performed Against Their Benchmarks
You will probably by now be familiar with SPIVA, Standard and Poor's regular study regarding how active managers fare against their benchmarks. The Fund Landscape is Dimensional's own take on this topic.
The document linked above clearly shows three important truths about investment management:
Less than half of actively managed funds survive for 20 years and even fewer outperform over this time.
There is no evidence to suggest funds doing well now will continue to do well, making consistently picking winners impossible.
High costs and fees are directly related to poorer performance.
Dimensional has addressed these points clearly with supporting data and charts. The evidence displayed here is key to our passive-leaning investment philosophy.
The Stock Market vs. Stocks in the Market
By David Booth, Dimensional Chairman and Founder
The collapse of First Republic Bank is a harsh reminder that any stock can go to zero, no matter how established a company is, or how loyal and wealthy its customers are. The failure of what many considered to be a rock-solid regional bank should serve as powerful evidence of the importance of diversification, what I consider to be one of the first principles of investing.
If your wealth is highly concentrated in any one individual stock, take this opportunity to learn an important lesson: While many people think they know more than other investors, none of us knows more than the market.
Many years before he became a Nobel laureate, my friend and mentor Merton Miller used to say, “Diversification is your buddy.” Diversification is the practice of spreading investments across a variety of assets. It’s a time-tested strategy to mitigate risk. Children learn about it early in life with the phrase “Don’t put all your eggs in one basket,” but all too often, grown-up investors forget.
I think it’s safe to assume that the total value of the stock market will not go to zero. But the same cannot be said about any individual stock, no matter how promising the future of a company might seem. Why not? Because we cannot predict the future.
The current price of any stock reflects the value of all its future income streams, but it’s no guarantee. Some companies fail. Can anyone predict which ones? Fortunately, there’s no need to. You can have a positive investment experience without knowing what’s going to happen with any individual stock because of diversification. In investing, diversification is the closest thing any of us can have to a free lunch.
Nearly all investing horror stories start with a simple fact: Someone took too much risk. In the case of First Republic, management took too much risk. But investors don’t have to. Anyone who lost their shirt when FRB stock lost its value had too much invested in it. Everyone who invests in the stock market should prioritize diversification in their portfolio. And it’s never been easier to do so, because with mutual funds and ETFs—many of which allow you to invest in a broad range of stocks by buying just one security—you can achieve a high level of diversification with the same number of clicks as buying a single stock.
In my opinion, when you concentrate your wealth in single stocks, you’re gambling, not investing. And that’s fine, as long as you don’t mind losing what you bet. First Republic has been included as part of the S&P 500 index since 2018. On the day JP Morgan Chase announced that it was taking over the troubled bank, how did First Republic’s dissolution impact the S&P 500?1 When the market closed, the index was down 0.039%2.
Now do you see why diversification is your buddy?
FOOTNOTES
1“First Republic Bank Is Seized, Sold to JPMorgan in Second-Largest U.S. Bank Failure,” Wall Street Journal, May 1, 2023.
2S&P data © 2023 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Decrease of 0.039% was on May 1, 2023.