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[Prefer to listen? You can find a podcast version of this article here: E227: Should I Invest in the Current "Hot" Stock?] 

Investing in the biggest names in the stock market has always been tempting. These giants of the industry are often household names with a reputation for market dominance, and their stocks can potentially deliver impressive returns.

However, jumping on the bandwagon of these big players isn't always a smooth ride. It comes with risks that investors might not always recognize.

The draw of investing in big stocks is their perceived stability and potential for growth. These companies usually hold their top spots due to years of innovation, successful acquisitions, and effective management. Their size and resources can make them seem like safe bets, capable of producing high returns.

The constant media buzz and analyst coverage can further boost investor excitement, driving prices up even more.

However, chasing after the biggest stocks isn't without its downsides. Despite their apparent invincibility, these companies aren't immune to the same market challenges that affect everyone else. In fact, their sheer size can make them more susceptible to changes in consumer preferences, technological disruptions, and regulatory shifts.

As more investors flock to these stocks, valuations can get inflated, making sharp corrections more likely if growth expectations aren’t met. Additionally, concentrating a significant portion of your investment in just a few big stocks can lead to a lack of diversification, which means you could face substantial losses if these companies stumble.

Understanding the risks and rewards of investing in big stocks is important for making informed decisions. While these companies might offer attractive returns and a sense of stability, they aren't a guaranteed recipe for success.

Investors need to consider factors like valuation, competition, and the potential for disruption. They should also be aware of the risks that come with putting too much of their portfolio into a few large companies, as this can magnify losses during market downturns.

Historical performance

Looking at the historical performance of the biggest stocks shows a mixed bag that challenges the idea of their invincibility. While these giants have often delivered great returns over the long haul, their performance compared to the broader market has been inconsistent. At times, the biggest stocks have lagged behind smaller companies, highlighting the need for a nuanced investment approach.

A prime example of this is the dot-com bubble of the late 1990s. Back then, tech giants soared to astronomical valuations. But when the bubble burst in 2000, these same stocks took a nosedive, with many never regaining their previous highs. This serves as a reminder that even the most dominant companies aren't immune to market corrections and the dangers of excessive optimism.

In more recent years, the performance of big stocks has been varied. After the global financial crisis, large-cap stocks in defensive sectors like consumer staples and healthcare outperformed the broader market as investors sought stability. But as the bull market gained momentum, smaller companies and those in cyclical sectors began to outpace their larger peers, driven by economic recovery and a renewed appetite for risk.

The ups and downs experienced by big stocks during different market cycles are also worth noting. Although these companies are often seen as stable, they're not immune to market swings. Economic uncertainty or market stress can lead to significant price swings, as seen during the 2008-2009 financial crisis and the COVID-19 sell-off in early 2020.

Concentration risk

One major risk of investing heavily in the biggest stocks is concentration risk. This happens when a large part of your investment portfolio is tied up in a small number of stocks, sectors, or asset classes. With big stocks, concentration risk arises when too much of your portfolio is allocated to these market giants, leaving you vulnerable to company-specific risks and market fluctuations.

The impact of concentration risk on diversification and risk management is significant. A well-diversified portfolio spreads risk across a broad range of investments, minimizing the impact of any single stock or sector on overall performance.

However, when investors chase big stocks and allocate a large portion of their portfolio to these companies, they effectively put all their eggs in one basket. This approach can lead to significant losses if these stocks take a hit, as the portfolio's performance becomes heavily dependent on a few large companies.

Furthermore, big stocks often belong to a limited number of sectors, such as technology, healthcare, or financial services. By concentrating investments in these sectors, investors expose themselves to sector-specific risks like regulatory changes, technological disruption, or shifts in consumer preferences.

For instance, the technology sector has driven much of the market's growth in recent years, with a few mega-cap stocks accounting for a significant portion of the gains. However, this concentration also makes investors vulnerable to the sector's volatility and the potential for sudden corrections.

To manage concentration risk, investors need to approach big stocks cautiously and maintain a well-diversified portfolio. This means spreading capital across various companies, sectors, and asset classes, considering factors like market capitalization, geographic exposure, and risk-return characteristics.

By diversifying, investors can reduce their reliance on any single stock or sector, managing risk more effectively. Regular portfolio rebalancing can also help maintain the desired level of diversification, ensuring the portfolio aligns with the investor's risk tolerance and long-term goals.

Valuation concerns

One concern with big stocks is their valuation, especially during periods of market exuberance. As enthusiasm for these giants grows, their stock prices can become disconnected from their underlying fundamentals, leading to inflated valuations that might not be sustainable.

This is often driven by fear of missing out (FOMO), extrapolating past growth rates into the future, and believing these companies are immune to challenges faced by smaller firms.

It is important to consider valuation metrics when making investment decisions. Metrics like the price-to-earnings ratio (P/E), price-to-sales ratio (P/S), and price-to-book ratio (P/B) provide insights into a stock's relative expensiveness compared to its peers and historical valuation.

When these ratios are significantly elevated, it can signal that investors are overpaying for growth, leaving little margin for error if the company doesn't meet high expectations. This is particularly true for big stocks, as their large market cap means even small missteps can significantly impact their valuation.

Overpaying for growth carries several risks. When investors chase big stocks without regard for valuation, they expose themselves to potentially significant losses if growth slows, competition intensifies, or unexpected challenges arise. This risk is heightened because big stocks often trade at premium valuations, reflecting their perceived stability and growth potential.

However, when expectations aren't met, corrections can be swift and severe as investors reassess their assumptions and adjust growth projections.

Moreover, valuation concerns with big stocks can have broader market implications. When a few large companies dominate market capitalization and trading volume, their performance can heavily influence market sentiment and overall returns. This can create a feedback loop, where the success of these stocks attracts more capital, driving valuations higher and increasing the potential for a painful correction.

Investors need to be mindful of the systemic risks posed by the concentration of market value in a few large companies and the potential for contagion if these stocks falter.

Survivorship bias

When evaluating the performance of big stocks, it's essential to consider survivorship bias. This bias occurs when we focus on the companies that have succeeded and remain prominent while overlooking those that have failed.

Survivorship bias can lead to an overly optimistic view of big stocks' performance, as it doesn't account for companies that have disappeared or seen their market value significantly diminish over time.

Survivorship bias is especially pronounced given the market's dynamic nature and constant churn of companies. Over the years, many once-dominant companies have fallen due to technological disruption, changes in consumer preferences, or mismanagement.

These fallen companies remind us that even the most successful companies aren't immune to business challenges. Investors might miss lessons from those who stumbled by focusing solely on surviving big stocks.

Investors should consider all companies, including those that have fallen out of favor or disappeared, to gain a more accurate understanding of big stocks' performance. This comprehensive view helps contextualize the success of current market leaders.

Studying the downfall of once-great companies allows investors to identify potential red flags and adjust their strategies. Moreover, considering the full spectrum of companies highlights the risks of concentrating portfolios on a few big stocks, as history shows that even dominant companies can fall.

Diversification strategies

While investing in big stocks is tempting, a smarter approach to building a portfolio involves diversifying across various companies, sectors, and asset classes. By spreading investments beyond market giants, investors can mitigate concentration risks and position their portfolios for long-term success. This strategy recognizes the market's constant evolution and that today's winners might not be tomorrow's champions.

One effective diversification method is investing in a mix of large-cap, mid-cap, and small-cap stocks. Large-cap stocks offer stability and steady growth, while mid-cap and small-cap stocks often provide greater potential for capital appreciation. These smaller companies might be less well-known but can be nimbler and more responsive to market changes. Including a range of company sizes in a portfolio balances risks and rewards, potentially enhancing overall returns.

Sector diversification is another critical component of a well-rounded investment strategy. Investing across various sectors, like technology, healthcare, financial services, and consumer discretionary, reduces exposure to industry-specific risks and capitalizes on unique growth opportunities in each sector. This approach also provides a natural hedge against market volatility, as different sectors perform better at different economic cycle stages.

Beyond stocks, investors should diversify across asset classes like bonds, real estate, and commodities. Each asset class has a unique risk-return profile and can play a valuable role in a well-constructed portfolio.

Bonds can provide income and mitigate stock volatility, while real estate and commodities offer an inflation hedge and diversify away from traditional financial assets. Allocating capital across various asset classes creates a more resilient portfolio that can weather market ups and downs.

Ultimately, most investors would be well-served by investing primarily in broad market mutual funds or ETFs that provide a high level of diversification across these categories.

Investing responsibly while scratching the itch

So what should you do if you just can't resist investing in the latest hot stock? Try compromising with new money.

Instead of reallocating your existing investments, set up a brokerage account that is just for investing in the trending stock that interests you. Don't change your existing contributions (for example, keep your 401(k) or Roth IRA contributions the same). Invest additional funds into this brokerage account and invest it in the stock.

This works because you are not sacrificing your existing financial plan to chase a hot stock and can still scratch the itch and put new money into it. It's effective because it forces you to be honest with yourself about your priorities. In order to free up money to invest in the stock, you may need to cut back on other areas of your budget so you get to see how important it really is to you.

Investing in the biggest stocks shouldn't be taken lightly. While these giants might offer substantial returns and stability, they come with risks and challenges. The allure of these stocks can lead investors to overlook essential factors like valuation, concentration risk, and the potential for disruption.

Successful investing requires a thoughtful, disciplined approach prioritizing long-term value creation over short-term gains. By looking beyond the hype and focusing on sound investment fundamentals, investors can build portfolios better equipped to handle market challenges and deliver sustainable, long-term returns.