Market prices have shown us that certain companies have benefited from the way society has changed during the COVID-19 crisis. A group of tech-focused businesses, referred to as FAANG stocks, have seen their share values increase in ways that are challenging to put in perspective.1 As my friend and colleague Gene Fama said recently:
But despite Gene’s warning, stocks with 34% returns are pretty alluring to investors. This is because of what I think of as the seductive nature of fat tail distributions. The term “fat tails” is used to describe outliers in stock returns. Research has shown that there are many more extremely good and extremely bad returns than might seem reasonable. Fama wrote about fat tails in his dissertation 50 years ago, and the other day he said:
His research partner, Ken French, continued:
Ken and Gene have spent their careers trying to figure out what expected returns are. Yet when we’re meeting with clients, we’re largely talking about unexpected returns, whether extremely good or extremely poor. FAANG stocks may make up part of a well-diversified portfolio. But a well-diversified portfolio is much more than those five stocks. That’s why it’s so important not to fall for the sirens singing songs of fat tails.
1 Facebook, Amazon, Apple, Netflix, and Google (a subsidiary of Alphabet) are often referred to as the FAANG stocks.
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