Why you shouldn't load up on Apple and Facebook

Apple and Facebook are hot topics in investing right now, but investors should consider the fates of other high-flyers before investing in these companies. Flickr user Marco / Zak

(MoneyWatch) On April 10, Apple's (AAPL) stock hit an all-time high of $644. Roughly a decade earlier, it traded at under $13. That's a price increase of about 50 times. The meteoric rise has resulted in Apple now having the largest market capitalization of any stock, approaching 5 percent of the total market.

Watching or reading the financial news, you persistently hear that Apple is a must-own stock, sure to be the first stock with a market cap of $1 trillion. And we're hearing the same type noise about Facebook, which is scheduled to go public next month.

One of my favorite sayings is that there's nothing new in investing -- just the investment history you don't know. So here's today's history lesson. Once upon a time, there was a group of "one-decision" stocks known as the "Nifty Fifty." You just had to buy and hold them (hence the term "one-decision"). Although there was no formal list, typically included were companies that dominated their industries in ways similar to how Apple and Facebook dominate theirs. Among them were Burroughs, Data General, Citicorp (then known as First National City), Digital Equipment, Eastman Kodak (EK), M.G.I.C. Investment Corp., Polaroid, Sears (SHLD), S.S. Kresge, and Xerox (XRX).

Notice anything? All of these companies are ones you wouldn't have wanted to have owned. What happened to these once great businesses?

"Creative destruction" describes the way in which capitalist economic development arises out of the destruction of some prior economic order. The companies in the list above were all victims of that process. And it's certainly possible, if not certain, that the same thing will one day happen to Apple and Facebook. No one knows when it might occur. What we do know is that technology is evolving so rapidly that it wasn't long ago that such sure things as Netscape, Intel (INTC), Cisco (CSCO) and Microsoft (MSFT) were the Apples and Facebooks of their day. Yet every one of them has seen their stock prices collapse and never come close to recovering over the past 12 years.

Prudent investors don't speculate. They only take risks for which they're compensated. They recognize that the market doesn't compensate them for the idiosyncratic risks of individual companies that can easily be diversified away. Thus, they avoid owning individual stocks. Instead, they own passive asset class or index funds that basically own all the stocks in an entire asset class or index. These vehicles eliminate the single-company risk in a low-cost and relatively tax-efficient manner. The trade-off is that they give up the potential of owning the equivalent of the winning lottery ticket. In return for that sacrifice, they eliminate the risk of having their eggs in one basket (or a few baskets), only to see creative destruction gradually -- or suddenly -- reduce that basket to splinters.

Given the well-known benefits of diversification, why do so many investors buy individual stocks? Among the many reasons is that investors:

  • Tend to be overconfident of their skills. Even those who admit it's tough to beat the market believe they will be among the few that will.
  • Confuse the familiar with the safe. Being familiar with a company leads investors to believe they have what might be called "value-relevant" information, when almost certainly what they know is well-known by the "market" and is already incorporated into prices.

Hopefully, you are now a more informed investor. Forewarned is forearmed.

Photo courtesy of Flickr user Marco / Zak

  • Larry Swedroe On Twitter»

    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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