Like most books and pundits that speak of investing, ignorance of the 80/20 rule is a prerequisite. Speaking of the 80/20 rule, the 80% of investors who emphasize diversification will always lose to the 20% who actively seek a specialized portfolio, whether that portfolio is focused on maximizing gains or hedging against a market crash. But in investing, perhaps the 90/10 rule is more accurate: year by year, the top 10% of the market’s stocks have consistently produced positive gains.
The problem is identifying which of those stocks will fall in the top 10%. But the fact that this always-positive performance that persisted throughout market corrections and crashes implies that investors can always be long, provided they know where to invest. The FANG stock phenomenon is the most recent attempt to pinpoint the top performing stocks.
FANG refers to Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX) and Google/Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL). Indeed, these stocks have consistently outperformed the market, and a portfolio with just these four growth stocks would have beaten the SPDR S&P 500 ETF (NYSEARCA:SPY) every year. And because these four stocks are in the SPY’s holdings, they carry much of the SPY’s weight (kind of like you did in that school project while your classmates goofed off).
So what about just holding the FANG stocks – could you beat the SPY? That depends on the period in question. And it’s not even about them being high beta stocks. For example, in 2012, a FANG portfolio broke even with the SPY but suffered double the average drawdown and almost double the max drawdown.
Still, over time, FANG beats the SPY. The question I intend to answer today is how to best allocate your capital to each of the FANG stocks. This is under the assumption that you are dedicating a portion of your portfolio to FANG. (Do not put everything in FANG, please!)
Let’s Get Serious
So here’s the study in question. It is derived from the concept of genetic algorithms, which you can safely ignore. Just know this: The idea here is to generate as many possible portfolios of uniquely weighted FANG stock allocations as my seven-year-old (!) ASUS laptop can handle and instruct my code to choose from those portfolios the one that produces the best tradeoff between maximizing gains and minimizing volatility as well as drawdowns.
Let’s skip the technical details and get right to the results. Let’s get serious – here’s the ideally weighted FANG portfolio:
- FB: 11%
- NFLX: 6%
- GOOG: 64%
- AMZN: 19%
The results tell us quite a bit about the FANG stocks. First, GOOG is clearly the best investment here in terms of its contributions to gains in respect to volatility and drawdowns. From a fundamental standpoint, this would seem to make sense as GOOG is a one-trick pony, monopolizing search engine ad revenue. FB is also a one-trick-pony in this sense, but perhaps social media advertising revenue is less reliable than search engine revenue.
NFLX being the lowest-weighted makes me happy. But it won’t bring back the tens of thousands of dollars I’ve lost shorting NFLX in 2015. NFLX is simply too volatile to have a place in a “balanced” FANG portfolio.
Finally, here is what your portfolio would have looked like if you had built it in the first year in which all the stocks were readily available:
As you can see, you would have outperformed the SPY every day, not once does the portfolio dip below the SPY. The volatility and drawdowns are naturally higher than a portfolio of 500 stocks, but really not that much higher when you remember we are looking at a portfolio of four stocks, one of which occupies more than 50% of the portfolio. Still, the takeaway here should be how to weigh your FANG stocks – not to put half your money in GOOG (though if you did, I certainly wouldn’t call you stupid).
This year, I predict bad things for the market. But as I pointed out in my article on the bursting biotech bubble, holding onto the winners in the market is safer than diversifying, contrary to what the majority of books and pundits preach. The above FANG portfolio might be a better bet than a diversified basket of growth and value stocks in 2016.
If you’re interested in looking at a different set of stocks to be weighted, let me know in the comments section, and I’ll run my algorithm on your set of stocks.
Learn More about Earnings
My Exploiting Earnings premium subscription is now live, here on Seeking Alpha. In this newsletter, we will be employing both fundamental and pattern analyses to predict price movements of specific companies after specific earnings. I will also be offering specific strategies for playing those earnings reports.
We have accurately predicted earnings surprises 100% of the time (7/7).
This week, we look at Nvidia (NASDAQ:NVDA).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.