3 Things 10-5-26

 Thing One

Is AI Making Your Portfolio Less Diversified Than You Think?

Artificial intelligence has been one of the biggest investment stories of the last few years. Companies tied to AI have produced enormous gains, and many of them are now among the largest companies in the S&P 500. That has been great for investors, but it also creates an interesting question: Are you as diversified as you think you are?

Consider what the S&P 500 looks like today. As of the end of August, information technology alone represented about 38% of the index. Nvidia, Apple and Microsoft were its three largest holdings, followed not far behind by companies including Amazon, Alphabet and Broadcom. In other words, an investor who puts $100,000 into an S&P 500 index fund isn't really spreading $200 evenly across 500 companies. A much larger portion of that money is being directed toward a relatively small group of enormous companies, many of which are either directly involved in AI or spending billions of dollars to develop it.

Now imagine that same investor also owns a technology ETF, a large-cap growth fund and a few individual stocks like Nvidia, Microsoft, Amazon or Alphabet. On paper, that might look like five or six different investments. Look underneath them, though, and the investor may simply own larger and larger doses of the same companies. The concentration becomes even more obvious inside technology itself. In S&P's capped Information Technology index, the ten largest companies recently accounted for about 75% of the index.

None of this means I think investors should sell successful technology companies. Quite the opposite. Many of these businesses have tremendous earnings, cash flow and competitive advantages. And this isn't simply a market running on a good story. FactSet currently expects S&P 500 earnings to grow about 29.5% year over year in the third quarter, with technology among the sectors expected to produce double-digit earnings growth. More than 65% of S&P 500 earnings calls in the second quarter also mentioned AI. AI is having a very real impact on corporate America.

The issue is concentration, not whether AI is real. Diversification isn't about making sure you own enough ticker symbols. It's about making sure one company, industry or investment theme can't determine the outcome of your entire portfolio. Owning an S&P 500 fund, a technology fund, a growth fund and several technology stocks may create the appearance of diversification without providing nearly as much of it as you think.

Thing Two  

The Market Is "Expensive", Does That Mean You Should Sit In Cash?

One of the hardest things about investing is putting money into the market when stocks have already risen substantially and seem expensive. It's much more comfortable to buy after prices have fallen. Unfortunately, when that happens, the headlines are usually terrible and investors are often even more reluctant to buy. So when markets are near their highs, it's natural to wonder whether it makes more sense to leave your money in cash and wait for a better opportunity.

But before deciding the market is too expensive to invest in, it's worth asking what "expensive" actually means. Stock prices alone don't tell us very much. What matters is what investors are paying relative to the earnings those companies produce. One common measure is the forward price-to-earnings ratio, or P/E. FactSet estimates the S&P 500 is currently trading at about 19 times expected earnings over the next 12 months. That's roughly in line with its 10-year average of 19.1 and actually below its five-year average of 19.8. Earlier this year, however, the forward P/E had climbed above 21. In other words, stock prices remain high, but rapidly growing corporate earnings have helped valuations catch up.

Those earnings numbers are significant. Analysts currently expect S&P 500 earnings to grow about 29.5% year over year in the third quarter, which would make it the third consecutive quarter with earnings growth above 25%. Revenue is expected to grow about 12.3%. So while investors are paying healthy prices for stocks, corporate America is also producing healthy earnings growth.

Still, it's easy to understand the temptation to sit in cash and wait for a correction. Suppose you have $100,000 to invest but decide you'll wait until the market falls 15%. That sounds perfectly reasonable. The problem is that you don't know where that 15% decline will start. If the market rises 20% before falling 15%, your hypothetical $100,000 investment would first grow to $120,000 and then fall to about $102,000. After the correction you've been waiting for, the market would still be about 2% higher than when you decided it was too expensive.

That's the problem with market timing. You have to make two correct decisions: when to stay out and when to get back in. The second decision may actually be harder because a market decline usually comes with a very convincing reason not to invest.

None of this means valuation doesn't matter. It absolutely does. The price you pay affects the return you're likely to earn over long periods of time. But valuation is much better at helping us estimate long-term returns than predicting what stocks will do over the next six months.

For someone uncomfortable investing $100,000 all at once, there's also a large middle ground between investing everything today and leaving everything in cash. You could invest $25,000 today and another $25,000 every few months. If the market declines, later purchases occur at lower prices. If the market continues higher, at least some of your money participated in the advance. That's not necessarily the strategy that will produce the highest return—we can't know that in advance—but it can be a sensible way to manage the emotional side of investing.

The market will eventually have another correction. We just don't know whether it starts tomorrow, six months from now or after stocks have risen another 20%. Successful investing doesn't require knowing which happens next.

Thing Three

Just A Thought  

“Success is not the key to happiness. Happiness is the key to success. - Albert Schweitzer