Investors expecting FAANG1 stocks to continue the extraordinary performance of recent years must be disappointed by their returns to date in 2022 (see Exhibit 1). Four of the five stocks lagged the broad US market through May 5, with Google, Amazon, Facebook (now known as Meta), and Netflix suffering big-time losses. Collectively, the famous five underperformed the Russell 3000 Index2 of U.S. stocks by nine percentage points.3 Things have not improved since that date.
Cumulative returns of FAANG stocks, January 1, 2022 – May 5, 2022
Source: Bloomberg. Facebook and Google now known as Meta and Alphabet, respectively. Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.
This year’s sharp reversal is a reminder that investors should exercise caution assuming past returns will continue. FAANG stock performance of the past decade reflected these companies financial success exceeding most investors’ wildest dreams. Now that’s history. Even if these companies could sustain their past success (and prospects look particularly poorly for Netflix!), it may not translate into spectacular future stock returns. Excellence from the FAANGs likely is already priced into investors’ expectations, so that high above-market returns for shares is unlikely.
Investment returns have two parts: the expected return and the unexpected return. The expected return is the best guess of what will happen based on all the information currently available. The unexpected return is the surprise element in a financial model. It is the difference between what happens and what was expected to happen. Investors should plan forward looking portfolio decisions on expected returns, not looking backward to recent realized returns. Over long periods, the two can differ by a lot, especially with individual stocks.
Given their big returns over the last ten years, how should we guess for planning purposes for how the FAANG stocks will do over the next decade? Is it realistic to expect an average annual return of almost 28% again?
Absolutely not. Who wouldn’t buy these stocks if they knew with confidence their expected returns were 28%? But buyers need sellers. The demand driven by such high expected returns would already have pushed prices up. Expected returns then would be driven down to a much lower level. The firm’s cost of capital is the investor’s return. For the same reason, if we could go back to January 2012, likely we would find few investors predicting the FAANG stocks would have a great decade of success.
So what does explain the FAANG stocks’ high realized returns? Their unexpected returns. Things turned out much better for them than investors expected in 2012. The companies’ cash flows over that decade were much higher than market participants expected. Their prospects looking forward from today are still better than what investors expected ten years ago.
All this unexpected, good news produced unusually high unexpected stock returns persisting for a decade. It would be poor planning to build a strategy assuming similar high unexpected returns to persist another ten years. Counting on good luck doesn’t make sense. A repeat of something equivalent to the COVID lockdown and government spending is unlikely. The expected value of the unexpected returns for sensible planning purposes must be zero.
In short, the past decade of extraordinary, realized returns tells us little about the FAANG stocks’ future expected returns. And unfortunately, this is typical. For most investment horizons—a month, a year, five years, even ten years — the realized return of a stock or even an index asset class is driven far more by the unexpected return than the expected return. Hence the importance of diversifying a portfolio and systematically allocating in asset classes defined by financial science.
As footnotes located under charts remind us, past performance is no guarantee or even an assurance of future returns. Wishful thinking that hopes for the best is not likely to lead to success. Relying on a trusted CFP® professional will help you gain needed clarity, discipline, and courage.
1Facebook-parent Meta; Amazon; Apple; Netflix; and Google-parent Alphabet.
2Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Index has been included for comparative purposes only.
3FAANG stock returns are computed as the average of Facebook (Meta), Apple, Amazon, Netflix, and Google (Alphabet share classes A and C) weighted by market capitalization at beginning of month.