Ken French had this to say today on the Dimensional blog about the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google):
Investment returns have two parts: the expected return and the unexpected return. The expected return is the best guess of what will happen based on all the information currently available. The unexpected return is the surprise, the difference between what does happen and what was expected. Investors should base their portfolio decisions on expected future returns, not recent realized returns, and the two can differ by a lot.
Look at the returns on the so-called FAANG stocks–Facebook, Amazon, Apple, Netflix, and Google’s parent company, Alphabet. Over the 10 years from September 2010 to August 2020, a portfolio of the five stocks held in proportion to their market caps would have delivered an average annual return of 34.25% per year. That means on average, the value of the portfolio doubled about every 2.5 years.
Given their great returns over the last 10 years, what is our best guess of how the FAANG stocks will do over the next decade? Should we expect an average annual return of almost 35% again? Absolutely not. Who wouldn’t buy these stocks if their expected returns were 35%? But buyers need sellers. The demand driven by such high expected returns would simply push prices up and drive expected returns down to a more reasonable level. For the same reason, I’m confident that if we could go back to August 2010, we would find few investors predicting the FAANG stocks would do as well as they did from 2010 to 2020.
So what does explain the FAANG stocks’ high realized returns? Their unexpected returns. Things turned out much better for them than investors expected. The companies’ cash flows over the last 10 years were much higher than investors expected 10 years ago, and their prospects looking forward from today are almost certainly better than investors expected they would be 10 years ago.
All this unexpected good news produced high unexpected stock returns over the last decade. It would be wrong, however, to expect high unexpected returns to persist. After all, it doesn’t make sense to count on good luck. The expected value of the unexpected returns must be zero.
In short, the past decade of extraordinary realized returns tells us little about the FAANG stocks’ future expected returns. And unfortunately, this is a general result. For most investments and most investment horizons—a month, a year, five years, even ten years—the realized return is driven far more by the unexpected return than the expected return.
How will it end for the FAANG stocks and the Large-Cap Growth, S&P 500, and Vanguard Total Stock Indexes that are dominated by these companies? We can't say for sure, but the 2000-2009 period might give us a clue.
The Price/Book (P/B) Value on the Fama/French US Large Growth Index in July topped 8.50, eclipsing the previous high level in 2000 (source: Ken French data library). Looking back to 2000, the next ten years was devastating for the large growth companies that dominate a number of common index funds.
If a -40%, or -33%, or even -9% cumulative return on your investments over the next ten years would cause you to fall short of your long-term goals, it's time for you to consider diversifying your portfolio more broadly. That result might not be the most likely scenario; but it's entirely possible.
The Dimensional Equity Balanced Index is an example of a more diversified portfolio -- it holds just 20% in the S&P 500 Index, with the remaining 80% split amongst other global stock asset classes in the value and small cap categories. A diversified portfolio doesn't work as well in the midst of a stock mania, when one small sliver of the market is growing exponentially. But when the music stops, diversified investors are happy they took the slow and steady approach to investing.
I'd say now is definitely the time to locate a seat.
Source of data: DFA ReturnsWeb
Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.