I think way too much about dead economists. I probably think too much about live ones as well, but that is another subject. Lately, I have been pondering Frédéric Bastiat, the French economist who in 1850 wrote his famous essay That Which is Seen, and That Which is Not Seen. In it, Bastiat disproves the “broken window fallacy” which claims that replacing a shoemaker’s broken window stimulates the glazier’s business and the economy. The benefit to the glazier is seen, but what is not bought by the shoemaker whose window is replaced is not. To quote Bastiat, “if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library.” *
Bastiat’s words are often in the forefront of my mind because the incidents where we value the seen over the unseen occur so frequently. When we spend money to hurricane-proof our homes, we see the cost but not the benefit of avoiding hurricane damage. The same is true with our investments. People do not see the companies that they own in their index and mutual funds, so it is not real to them. For example, two popular technology companies account for more than 12% of the value of the S&P 500. These same two companies are the ones that clients most often ask me to buy. When I tell them that they already own them in their funds, they just tell me “I still want to own the stock.” Sometimes, clients end up with 20% or more of their equity portfolio in one company. They own it where it is seen and where it is unseen.
Yet, their ownership where they do not see it is just as real and has just as much of an impact on the risk/reward characteristic of their portfolios. When tech does well, they do well. When tech does poorly, they do poorly. Their volatility increases and the predictability of long-term returns declines, as does the confidence we can have that their objectives will be realized.
Because a handful of popular stocks are also widely held by so many funds, we see a reinforcing effect that contributes to the formation of bubbles. In 401ks, for example, investors will pick funds that all own the same popular stocks, which drives their prices higher and provides confirmation to those who own both the fund and the individual shares. Portfolio managers who own concentrated positions in these funds become cable-television celebrities, which drives even more money into these few companies. Then it comes to an end, as all bubbles must.
I shall channel the spirit of Bastiat in that “I am sorry to disturb these ingenious calculations…but I beg him to begin them again, by taking into account that which is not seen, and placing it alongside of that which is seen.” By doing so, we avoid unnecessary losses that harm us and the economy. Bastiat needed to point out the obvious when he wrote that “society loses the value of things which are uselessly destroyed.” Concentrated positions can lead to just such useless destruction.
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Bastiat, Frederic. That Which Is Seen, and That Which Is Not Seen. Oralndo, FL: WLC Books, 2010. Originally Printed: Ce qu'on voit et ce qu'on ne voit pas, ou l'Économie politique en une leçon. Par M. F. Bastiat, Représentant du peuple à l'Assemblée nationale, Membre correspondant de l'Institut (Paris: Guillaumin, 1850).