Worried about a bubble in stocks?

Diversification may be the answer you're looking for.

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Key takeaways

  • It's normal to be concerned about bubbles in a market hitting new highs. But not all stocks have been soaring like Apple, Amazon, and Alphabet. Many companies hit by the pandemic are actually relatively cheap.
  • To understand if stocks are expensive or cheap, try using valuation metrics like price-to-earnings or price-to-book ratios.
  • Diversifying the stock portion of your portfolio by company size (large, medium, and small), by style (like value or growth), and geography can help reduce volatility in your portfolio.
  • Rebalancing regularly can help keep your portfolio on track toward your goals.

2020 was a particularly good year to be an investor in large-cap companies. The S&P 500®, an index that tracks the 500 largest companies in the US, among other criteria, was up 65% year-over-year, as of March 15.

What may be surprising for some investors is that much of that growth was driven by just a few companies—Facebook, Amazon, Apple, Alphabet, Netflix, and Microsoft. For instance, Apple was up 101% year-over-year. The chart below, S&P 500 returns have been driven by a few companies (FAAANM), illustrates how that dynamic played out over the past few years. It has led some to wonder if there might be a bubble in large-cap companies, particularly these so-called FAAANMs—and if so, what can an investor do?

S&P 500 returns have been driven by a few companies (FAAANM)

Is the market in a bubble?

To understand if a stock, or the whole market, may be expensive you need more information than the price.

"Thinking about certain valuation metrics can help," says Naveen Malwal, institutional portfolio manager at Strategic Advisers, an investment unit within Fidelity. "That could be comparing the price of the stock to its earnings, book value, or sales. Then compare that to historical averages or some other reference point. You can do this company by company, across sectors and industries, or across broader markets, such as US or international."

And what if a company or sector does have a higher-than-average price-to-earnings ratio?

"A high valuation typically implies that future returns may be more modest than in the recent past. But more modest doesn't necessarily mean a market correction. For example, it could mean that rather than experiencing 15% or 20% gains, returns could be closer to 6% or 8%," says Malwal. (Keep in mind that it’s possible to see negative returns.)

Another point to remember: There are thousands of stocks in the US stock market. So even if some stocks seem pricey, many others probably remain attractively priced.

"Currently, for instance, a lot of companies that struggled with the pandemic have stock valuations that are more attractive than the average stock in the market. Hotels, restaurants, airlines—anything that needs people to get out and about could have a lower valuation right now," Malwal says.

How to bubble-wrap your portfolio

That's where diversification can help.

Though it may be a helpful mitigation strategy, it’s important to remember that diversification and asset allocation do not ensure a profit or guarantee against loss.

"The potential benefit of this is that many investors can still experience enough growth to reach their financial goals. Yet at the same time they're not beholden to the performance of just one part of the market, or one type of stock or one specific sector," Malwal says.

Investment winners and losers change over time

Different types of investments can play different roles

Having a mix of investments with varying risk and return characteristics can help investors reduce volatility in their portfolios over time. Consider investing in a wide range of companies, small through large, as well as different styles, such as value versus growth. Non-US companies can provide further opportunities for diversification.

The importance of dividends

Stocks that pay dividends have been a key contributor to total return and may provide a steadier stream of returns versus non-dividend-paying stocks.

Small caps: Diversification plus inflation protection

Historically, US small caps have generally done well when the US economy has been recovering from a recession. And what's more, since the 1930s, small caps are the only major asset class to outperform inflation in each decade. So, in addition to the potential diversification benefits against large caps, one reason to add some small caps to your investment mix may be as a hedge against inflation.

Bonds and diversification

For many investors, it can also make sense to diversify the bond portion of your portfolio. Different bonds can provide varying degrees of price stability, income, or total return potential. Depending on your situation, you may need bonds to play just one part—or all 3.

Read Viewpoints on Fidelity.com: Evaluating a bond fund and Bond investment strategies

Rebalancing can help manage risk

Because some parts of the market often do better or worse than others, your mix of investments won't always stay the same over time.

Rebalancing back to your original asset mix or a new mix based on your financial needs, time frame, and goals, you can help ensure that the level of risk and growth potential of your portfolio stays appropriate for your situation.

How Strategic Advisers at Fidelity manages money

Professional investment managers, like the investment team at Strategic Advisers, generally try to avoid reacting to market moves. Instead they try to follow the latest readings of the business cycle and the economy, and try to position their investments to match what has worked best in historical periods that have been similar.

"So as an example of this, over the course of the summer, we started to gain more confidence that the US was likely exiting a recession and entering an early cycle recovery. Therefore, we started to emphasize some of our growth stocks less, and moved more emphasis toward value stocks. We felt that many value companies struggled with sales and profits during the pandemic, but could outpace other parts of the market as the pandemic became less of a concern for the economy. We also added exposure to mid-size and small-sized companies. That's because after a recession, those parts of the market historically have outperformed larger company stocks," Malwal says.

"We also shifted some of our allocation toward international stocks because their valuations were attractive and their earnings outlook was improving," he explains.

You can try it at home

Building and maintaining a diversified portfolio is an accomplishment. It takes time and expertise to research and choose investments.

To try it on your own, keep these tips in mind:

  • Diversification can help your portfolio weather different types of markets.
  • Different types of investments may play different roles in your portfolio.
  • Consider using professionally managed building blocks, like mutual funds or ETFs.
  • Rebalance regularly to keep your investments on track.
  • Try to avoid reacting to short-term market moves and keep a long-term perspective.

Investors also have the option of letting someone else do this work for them. Target date funds, asset allocation funds, or managed accounts are all options for professional investment management.

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