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Once bitten, twice shy; Should you beware the FAANGs?

Once bitten, twice shy: Should you beware the FAANGs?

One of the biggest economic stories of the summer is the recent plight of Facebook. In late July, the company missed expectations on earnings and showed slower user growth. As a result, Facebook stock dropped 20%, ultimately losing $120 billion in market cap. That's roughly one-fifth of the company's value. What's more, Facebook's decline caused the S&P 500 to drop a full 1%.

The event brought new scrutiny to the so-called FAANG stocks-Facebook, Amazon, Apple, Netflix and Google. These growth stocks now represent 13% of the S&P 500-nearly double the percentage they represented in 2013 when Facebook joined the index. As a result, they can have an outsized effect on the market's movements.

For investors who may still consider large-cap stocks a relatively safe area of the equity market, this recent volatility highlights an important point: It's essential to build a diversified portfolio that looks beyond high-level asset classes such as stocks and bonds.

Not your grandfather's blue chips

In previous generations, large-cap stocks were often thought of as "blue chip" investments. Blue chips are frequently considered to be less risky investments than other equities; they're usually issued by established companies, and the shares are widely expected to be high-value, long-term investment vehicles that provide stable earnings.

Blue chips typically have strong balance sheets and cash flows, as well as business models that produce consistent growth. Many reward investors for that growth by using extra profits to make dividend payments. These benefits explain why many investors feel that blue chips are a good place to park their cash.

However, thanks to a new generation of tech companies, the terms "large cap" and "blue chip" may no longer be synonymous. Over the last decade, tech stocks have become the biggest companies in the world; in early August of this year, Apple became the world's first trillion-dollar company. As a result, these companies make up an increasingly large percentage of S&P 500. However, they don't behave like the blue chips of days past.

While today's large-cap tech stocks are growth stocks, they don't pay dividends. Rather, they reinvest profits to boost their own short-term growth. This quick growth, in return, creates increased volatility, both in individual stocks and in the market as whole. That's a far cry from the stability once offered by many blue chip stocks.

Building a diversified portfolio

The recent spread of FAANGs' volatility into the wider market provides a reminder of the importance of diversification. A properly diversified portfolio should provide capital appreciation while also managing volatility.

Wiley Group helps clients achieve this objective by investing in a broad range of asset classes, and by using the following strategies:

  • Exposure to dividend stocks.  Dividends provide cash flow, which reduces investors' need to draw income from their principal. This quality is especially important early in retirement. Preserving principal early on means investments have more time to grow, and investors will potentially have more money later on. It also reduces the risk that investors will have to draw money from their portfolio during down markets.

 

When choosing dividend stocks, it's critical that managers look for securities with a consistent history of dividend payments and reasonable expectations of strong future payments. Additionally, managers should balance yield and expected volatility to maximize cash flow.

  • Alternative investments.  Alternative investments, such as gold, managed futures or absolute return strategies can be an important addition to a diversified portfolio: They tend to have low correlation to stocks and bonds, so they reduce overall volatility. Alternatives may also provide differing risk and return characteristics than other asset classes, which may allow for further diversification in changing market cycles.

 

  • Global tactical asset allocation. Global markets tend to be uncorrelated to domestic markets to a certain extent. A tactical allocation to world markets allows investors to take advantage of portions of the world economy that are doing well, while reducing allocations to asset classes that are underperforming in a given market economy. 

 

A low volatility, highly diversified approach to portfolio construction simply makes sense in today's market. It can help investors avoid a surprise hit to their portfolios should one stock or sector stumble, as Facebook did this summer.

If you'd like to determine whether your portfolio is properly diversified and performing optimally, please visit our Portfolio Checkup page.