The success of the FAANG (Facebook (FB), Apple (AAPL, Financial), Amazon (AMZN, Financial), Netflix (NFLX) and Google (GOOGL) tech stocks has caught many investors and analysts by surprise over the past decade.
Few, including this author, would have thought ten years ago that companies like Apple, Amazon and Microsoft (MSFT, Financial) would grow to be the size they are today. All of these stocks are on the way to potentially becoming the world's first $2 trillion businesses.
These companies have succeeded for different reasons, but their progress over the past decade shows just how hard it is to pick tech stocks (and stocks in general) successfully. Indeed, for every $1 trillion-plus business on the market today, there are thousands of tech failures.
This is something Warren Buffett (Trades, Portfolio) explained in 2011 at that year's Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of shareholders. Answering an audience question about which sector he'd pick to own for the next 50 years, Buffett stated that if he could learn a lot about the tech sector, that's the one he'd pick.
However, as the chances of failure were so high for most tech businesses, he explained that he wouldn't invest without a deep understanding of the sector and companies involved:
"There are likely to be, you know, a few enormous winners, a lot of disappointments. So that the ability to pick the winners, you know, is far disproportionate to the ability to pick the winners, we'll say, among integrated major oil companies where they're all equated in price. You're not going to have a big edge in trying to pick Chevron (NYSE: CVX) against Exxon (NYSE: XOM) against Continental and Occidental (NYSE: OXY), and you name it. But the degree of disparity in results among larger tech companies in the future is likely to be very, very dramatic. And if I had the skills where I could pick the winners there, I would do a lot better than if I had the skills to pick the winners in the major integrated oil field."
This seems to suggest that Buffett understood the potential of tech in 2011. Still, it seems he declined to invest because he did not know enough about the sector, and with such a high failure rate for tech businesses, that makes a tremendous amount of sense.
Some might call Buffett too conservative for taking this approach, but that will be said with the benefit of hindsight. One thing we need to keep in focus as investors is the distorting effect of survivorship bias. It is possible to look back and say Buffett made a mistake today (may readers may also have made the same mistake), but it was the far safer decision at the time.
According to my estimates, three-quarters of stocks produce a negative performance over the long run. As such, the odds stand against average and professional investors. It's very easy to look back at a missed investment opportunity and call it a mistake, but with the odds of success so low, the chances of making a mistake at the time are higher.
Therefore, it makes sense to keep Buffett's quote in mind when picking stocks. Even if you know a lot about a sector or industry, it's never going to be possible to have a 100% investment success ratio. There will be failures, and investors need to accept that.
The best way around this issue for investors who know little about a sector is, in my opinion, to buy index funds and ETFs. The diversification offered by these products reduces the risk of failure. It also limits gains, but that may be a worthwhile tradeoff considering the high probability of owning a losing stock. It's a tradeoff between high profits, significant losses and sustainable profits.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Now More Than Ever, Investors Need to Know When to Sell
- Seth Klarman's 3-Stage Approach to Valuation
- Is Price-Book Ratio Still Relevant for Value Investors?
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