Should Index Investors Be Worried About Facebook?

Feature

If you’ve been paying any attention at all to financial news this week, you’ve probably heard about the large 19% drop that Facebook experienced on Thursday.  Facebook is the fourth largest company in the US by market cap — behind only Apple, Microsoft, and Amazon — and the total loss amounts to a staggering $120 billion wiped out.  That’s easily the largest single day loss by one company in recent stock market history, and if you’re personally holding a lot of Facebook stock you’re probably not a happy camper.

But let’s say you’re more the index investor type than the individual stock picker.  Should you be worried?

To help answer that, lets look at how Facebook stacks up against the big picture.

 

FB-SandP

 

This chart shows the relative sizes of every company in the US S&P500.  (The source data is courtesy of SlickCharts.com).  They’re sorted by market cap, and you can see how the larger companies represent proportionally more of the index than the smaller companies.  See that yellow sliver?  That’s Facebook.

I first considered showing a before and after version of the same chart on either side of the big Facebook drop, but changed my mind when I figured most people would not be able to detect the difference.  Then again, that’s exactly the point.  19% of a single stock is a really big deal, but 19% of even the fourth largest company in the index is still so small in the grand scheme of things that it’s nothing more than a blip.

Taking it one step further, what does that Facebook slice look like in the type of diverse portfolios you find here on the site?  As just one example, let’s check out its position in the Golden Butterfly.

 

FB-GB

 

Scared yet?  I imagine not.  The entire point of portfolio diversification via broad index funds is to minimize the risk of any one company misstep tanking your life savings, and images like this help reinforce how effective they are at doing just that.  So no, Facebook should not worry index investors in the slightest.

But before you get too comfortable, stop for a moment to think about what it would feel like to have a large percentage of your net worth in Facebook on Thursday.  Would a 19% drop have sent you into a panic?  Would it have delayed your retirement or otherwise substantially ruined your important life goals?  How terrible would you feel right now?

Cue dramatic music…

 

what-if-i-told-you

 

For perspective, the 19% loss Facebook experienced on Thursday is roughly equivalent to the 20% the S&P500 lost on October 19th, 1987, or “Black Monday.”  The company diversification that a stock index fund provides is no solace when the entire stock market fails you all at once, and major drops happen more often than you think.  Also, losses don’t automatically stop after a single day.  In fact, looking at year end data since 1970 the US stock market has experienced drawdowns as deep as 48% and as long as 13 years.  Forget Facebook.  Now that’s painful.

 

DD-SandP

 

So if buying a stock index fund with hundreds or thousands of companies is no protection from severe market pain, what are helpless investors supposed to do?  Throw up their hands and just learn to deal with it?

Here’s a hint.  Check out the same Drawdowns chart for the previously-mentioned Golden Butterfly.

 

DD-GB

 

You see, true diversification is about so much more than company count.  The types of assets matter, and how they each respond to specific economic conditions makes all the difference in the world in portfolio-level performance. To be a truly effective chef, you need to stop tossing only your favorite vegetables in the salad and think more like a baker with a sense of chemistry and an eye on the final dish.  Just like a good cake, a well-designed portfolio is much greater than the sum of its parts.

Now please don’t get me wrong.  Even if all of your money is in a single stock index fund today, you’ve made an excellent choice that is so much better than picking individual companies you probably don’t even understand, paying an expensive adviser, or even trusting a famous mutual fund manager who may just be lucky for all you know.  Many people are perfectly fine with the risk tradeoffs of the total market portfolio — I carry it on the site for a reason — and are comfortable riding out the bumps as they come.

But if you’ve never really thought about the risks or mistakenly believed that a Facebook-level drop is not possible for you, then maybe you should take a little time to study the topic and understand what you’re signing up for.  The good news is that the stocks you already own are likely a core asset for any future portfolio you might be attracted to.  So it’s not about changing plans altogether, but simply about continuing to build your long-term financial home on an already strong foundation.

Study a few well-known investing recipes, and you’ll start to appreciate how smart portfolio design can help you take the next step in your financial plan.  Avoiding the woes of Facebook makes for dramatic news and a good lesson in company diversification, but your portfolio deserves so much more thought than that.

Get cooking.