Last week, the Florida Panthers beat the Edmonton Oilers in a thrilling seven game series to win their first Stanley Cup. But today, we’re not talking about that Stanley Cup. We’re talking about this one.

I first noticed the Stanley cup craze last year during a group workout class. I was familiar with the cups but didn’t realize their budding appeal. As I sweated through the session, I couldn’t help but notice the number of people using Stanley cups. The craze for the Stanley cup hit home when my friend’s 7-year-old son made it tops on his wish list last Christmas. 

The proof is in the numbers: the 111-year old company behind Stanley cups saw its revenue grow tenfold in the past five years. The appeal for both young and old is clear – they’re colorful, comfortable, and popular. But fully understanding why people love them so much involves a bit of psychology.

The Mere Exposure Effect

The mere exposure effect is a psychological phenomenon where people develop a preference for things or people they see often. It’s also known as the familiarity principle, for obvious reasons. The more you see something, the more likely you are to like it.

This is evident with Stanley cups – the more you see them in gyms and offices, the more familiar and desirable they become. Their popularity feeds on itself.

The Magnificent 7: Investing’s version of Stanley Cups

There’s a parallel between the Stanley cup craze and investors’ fascination with Nvidia and the other “Magnificent 7” stocks: Alphabet (Google), Amazon, Microsoft, Meta (Facebook), Microsoft, & Tesla. These companies are so well known that most investors can easily identify them and their main products. 

Their stellar performance in recent years has only increased their visibility. Last year, these seven stocks had a collective return of 76%, compared to just 8% for the rest of the S&P 500. In the first half of 2024, they’ve returned 34%, compared to only 5% for the rest of the S&P.¹

Stocks with the best performance get the most media exposure. The greater the exposure, the more familiar they become. The more familiar they become, the more likely investors show a preference for owning these stocks. But is that a good idea?

Popularity Contests & Investing

Investing amplifies the mere exposure effect. Owning a Stanley cup might make you feel trendy; owning stocks like Nvidia & the Magnificent 7 might make you both trendy and rich! The desire to own popular stocks is strong, but it’s not always rational.

The mere exposure effect draws investors towards popular stocks like the Magnificent 7. The desire to chase these stocks is normal. But this human psychology might not even be the strongest allure. 

As the saying goes, “There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.” When you consider how successful investing is based on managing one’s behavior and temperament, this factor can’t be understated. 

This FOMO (fear of missing out) can lead even the most rational investor to make emotional decisions. Missing a party is one thing. Missing out on making money while our friends rake it in is an entirely different FOMO level that can put the most rational investor on emotional “tilt.”

Is owning Nvidia & the Magnificent 7 stocks a good idea? Let’s see if history can offer us any clues.

The Lessons of History

When stocks have such massive success as the Magnificent 7, it’s hard to envision anything stopping these industry behemoths from continuing to crush it…and yet it happens, all the time. 

The Nifty Fifty stocks of the 1960s and 1970s were once seen as stable buy-and-hold stocks that couldn’t go wrong regardless of how high their prices climbed. Popular investor sentiment overrode logical investing analysis of these companies for years, ultimately leading to a market crash that would last for nearly a decade into the 1980s.

But as the chart below illustrates, the largest companies in the world changing over time is the norm, not the exception. 

Here are several observations from the list of top global stocks by market value above:

• From 2000 to 2010, only 2 of the top 10 global stocks – Exxon Mobil & Microsoft –  stayed on the list
• From 2010 to 2020, only Apple & Microsoft stayed
• 4 of the top 10 stocks in 2020 have already fallen off the list
• Each of the Magnificent 7 were in the top 10 as of the end of 2023

Maybe there’s truth to the saying that it’s harder to stay on top than it is to make the climb.

Performance of the Biggest Stocks on the Block

It’s evident that the largest companies don’t often stay the largest. But more importantly, investors considering buying the Magnificent 7 should be interested in how the largest stocks have performed after becoming the biggest kids on the block?

The chart shows “excess” returns of the 10 largest U.S. stocks before and after joining the elite group. Excess returns is the amount those stocks out/underperformed the U.S. stock market during that time.

The chart illustrates that the closer to the sun these stocks got in terms of entering the top 10 list, the hotter they got, outperforming the market by an astounding 27% per year on average in the 3 years prior to inclusion.

But once they reached their moment in the sun, the backside of the sun cooled off fast as returns fell to just +0.6% outperformance the next three years. Over the long-term, the largest high fliers underperformed the rest of the market by 1.5% per year on average.

The Future of the Magnificent 7

How will the Magnificent 7 perform in the future? In the short term, it’s anyone’s guess as it’s hard to measure the mania of consumer sentiment that propels Stanley cups or individual stocks. But in the long-run, history suggests they might underperform their peers now that they’ve reached top 10 status.

The mere exposure effect can be dangerous in investing. The more familiar a company becomes, the more likely we are to want to invest in it. However, high past returns often lead to lower future returns, making these companies less attractive.

The challenge for investors is that the best returns come from companies before they enter the top 10, not after. Predicting those future winners is difficult because most stocks stink. Instead of looking for needles in a haystack, consider building a diversified portfolio that has good long-term returns when investing at market highs or lows.

Oh, and if you’re more worried about the Magnificent 7 being the next tech bubble to burst, we’ll discuss that next week…

Source: ¹ JP Morgan Guide to the Markets

Castle Quote: “I can calculate the motions of the heavenly bodies, but not the madness of people.” – Isaac Newton