I have been investing for 30 years. I have a good track record and have learned many important lessons. The four most important investing rules I have learned are the following:
Rule #1: Past Performance Does Not Guarantee Future Results
Rule #2: There are no exceptions to rule number one
Rule #3: I mean it. Really. No exceptions whatsoever. Absolutely none. Seriously. None!
Most CNBC talking heads will quickly agree with rule number one, but not with rule number two. They will state number one and then start giving you exceptions. The talking head will say, “Past performance is no guarantee of future results, but diversification is always a winner.” Another example, “Past performance is no guarantee of future results, but stocks always beat bonds in the long run.” Or the one I’m going to argue against, “Past performance is no guarantee of future results, but low-cost index investing is a long-term winner.”
Things are true until they are not. Birds fly and humans do not was true for thousands of years until 1903, when two bike mechanics mastered controlled aviation at Kitty Hawk, North Carolina. Today, people can fly across the country for less than a day’s wages.
For the last 40 years low-cost index investing consistently beats most stock pickers. It has been a great run and the way most people play the market. Things change. Last summer the Nasdaq 100 index rebalanced, lowering allocations to: Microsoft, Nvidia, Apple, Amazon, Google, Meta, and Tesla. The reason? Those companies are too successful. Index diversification is mandated and the big seven started to take over the index. The Nasdaq 100 index has the rule: if all stocks that are more than 4.5% of the index sum up to 48% or more, then reduce the holding back to 40%. In July 2023, Nvidia was reduced from 7.2% of the index to 4.2%. NVDA is up 158% since that rebalance. Index investing has done reasonably well anyway. Diversification has been a long-term winner, but things are changing. Technology is becoming more important and is frequently winner take all.
What happens to the SPY and the QQQ if these trends continue? In 20 years, we could live in a world where the top five companies make 90% of the profits. In that world you need large allocations to those companies, but the indexes will regularly trim those stocks no matter how well they are doing, how cheap they become, or how big the dividends or stock buy backs. The index will hold losers and trim winners.
It gets worse. In a winner take all world, companies that have a chance of taking the new tech superstar mantel will be priced like options. This is true today and becoming truer all the time. If you own a dozen out of the money call options on big companies, most of those options will expire worthless and a couple will go way up. On average, you will break even minus costs if you are picking these options at random. When you look back and see that the option on XYZ went to zero, that does not mean it was mispriced. It was priced on the less than 50% probability that the option would expire in the money. Stocks are becoming more and more like options. Nvidia is priced on the possibility that AI will work, and buying hundreds of thousands of GPUs will be essential for all companies that want to be relevant. We may learn two years from now that productivity enhancing AI is 15 or more years in the future and NVDA crashes 80%. People will then say NVDA was overpriced, but it was not. It is an option on success. It might go up 10x in five years if cars drive themselves and Microsoft comes out with programming aids that resemble Jarvis from the Iron Man movies.
Index investing will underperform in a future where there are a few monster winners and dozens of stocks priced as options on the possibility of being a monster. For example, $10,000 invested in Tesla at the close of its first trading day in June 2010 is today worth $1.1 million. The SP500 index added TSLA on December 21, 2020. Tesla is down 23% since its first day in the SP500. SP500 index investors have lost money on Tesla where stock pickers have made a fortune on Tesla.
In the future, I’m predicting index investors will trim winners and hold losers. Potential new winners will be added to the index after already having a great run. Then if those new entrants fail, the index will hold them until they are almost worthless. If the new entrant is a winner and goes up 100x, it will be trimmed over and over. Index investing has a dark future.
If you agree with me, what should be done? Consider adding something like the “Founder Growth for Life” strategy that I suggested in my April 2nd post. Study Bitcoin and consider owning one of the Bitcoin ETFs (FBTC or IBIT). Own some real-estate. Don’t be afraid to do your own research and pick individual stocks. Let your winners run. But the real answer is,
Rule #4: There are no easy answers.