One of the hardest concepts to grasp in investing is that a ‘good’ company is not always a better investment opportunity than a ‘bad’ company.
If we believe that markets work pretty well, considering few investment professionals beat the market over time, and markets incorporate all public information into prices pretty quickly and efficiently, all of the ‘good’ and ‘bad’ news should already be reflected in these prices.
A ‘good’ company will have to do better than the aggregate expectation set by the market for its share price to rise and vice versa. If a ‘bad’ company is in fact a less healthy company, it may have a higher expected long-term return, as risk and return are related.
It is perhaps evident that if the market incorporates the aggregate forward-looking views of all investors, it becomes very difficult to choose which companies, sectors, and geographic markets are likely to do best, going forward.
In an uncertain world, where equity prices could move rapidly, and with magnitude, on the release of new information, which is itself a random process, then it makes good sense to ensure that an investment portfolio remains well diversified across companies, sectors and geographies.
Many charts illustrate how deeply diversified a globally equity portfolio can be however if you do not know which companies are going to perform well, own them all. However, in the US, the concentration risk of the S&P500, is quite different and is increasingly concentrated in a few names.
Given that all the future promise of a company is already reflected in its share price today, it is quite a risk betting a large part of your assets on just a few names, concentrated, for example, in the technology sector. The top 8 technology shares in the US now have a larger market capitalisation than every other non-US market except for Japan!
Dominance of companies, sectors and markets ebb and flow over time. What will be the next Amazon? What regulatory pressures could these dominant companies face? Is Donald Trump’s recent rage against Twitter the start? No-one knows.
By remaining diversified, you will own the next wave of market leaders as they emerge and dilute the impact of ebbing companies. Whilst it is always tempting to look back with the benefit of hindsight and wish we had owned more (take your pick), US tech shares, other growth shares, gold etc., what matters is what is in front of us, not what is behind us.