Economics teaches us about the law of diminishing returns. Here is how one economics dictionary defines the theory:2

“A concept in economics that if one factor of production (number of workers, for example) is increased while other factors (machines and workspace, for example) are held constant, the output per unit of the variable factor will eventually diminish.”

This is the unseen risk of the boom in computer science degrees for both the individuals pursuing them and the vast array of technology companies hiring them to compete with each other. Bill Gates, Paul Allen, Steve Jobs and Steve Wozniak did not even have a college degree when they formed Microsoft and Apple. Munger would say that they had total competence from the lack of competition! The writer, Malcolm Gladwell, would say that they got their ten thousand hours in on the computer before everyone else did. The benefit of getting into computer science could be diminishing very quickly under Munger’s theory and the risk goes unseen, masked by the boom in technology and the huge gains in the most popular technology stocks.

When tech companies with strong revenue growth and very little in profits see their shares rocking and rolling, young people are very motivated to get in on the industry action. The unseen risk of capital destruction has followed historically, when a big part of the stock market’s capitalization gets tied up in the most glamorous stocks. One of the telltale signs has been young people craving a piece of the action. When oil was $115 per barrel a few years ago and the Bakken shale fields were booming, colleges offering a geological engineering degree were buried with applications. The unseen risk is being played out via the current oil price of $42 per barrel and layoffs which are rampant in the oil business. It would be amazingly frustrating to U.S. investors if the shares of today’s glam tech stocks do poorly, because the possibility of it, on an across the board basis, is unseen.

3. Passive indexes have dominated most stock-picking methodologies and will do so forever.

We’ve seen estimates that 52% of the dollars invested in large-cap U.S. stocks are held in passive index vehicles. The index advantage is simple, seen and well documented. You get the market return (if you stay put) at a low cost by owning all the stocks in the S&P 500 on a capitalization-weighted basis. However, the risk in the index is currently unseen, because the index is aligned by its weightings and practices very low turnover (less than 5% per year over the last twenty years). Technology stocks are well over 20% of the S&P 500 Index and other than during the tech bubble are at the highest sector weighting and the biggest spread to the second largest sector as they have been since 1990. Historically, the index is at its worst when a prolonged era of success automatically allows proportional dominance from sectors which leave index investors with an unseen risk.3

It is not hard to figure out how to beat the index from a historical standpoint. Academic studies show that the cheap stocks in the index outperform the index over one, three, five and even seven-year time frames. Also, companies which fit certain quality characteristics, like strong balance sheets, sustainably high profits and low earnings volatility have proven to be long-duration winners. This has equated to our three main tenets of investing: 1) Valuation matters dearly; 2) We want to own businesses for a long time; 3) To do this we must own high quality businesses.

The most consistent unseen risk for index investors would be very poor performance in its largest sectors, and/or spectacular performance from industries which are very under represented. A negative feedback loop like this is what happened when the tech bubble broke in early 2000 and what happened to energy investments in 1981 and 2015. As an example, coming out of the bottom of the 2007-2009 bear market, banks were a very small part of the Dow Jones Industrial Average and restrained its results relative to the S&P 500 in 2009, when financials came storming back from extremely depressed price levels. If blue-collar trade-workers and the industries they work for make great money in a booming economy the next ten years, they are under-represented in the S&P 500 Index. If trades people out-earn those with a computer science degree, the unseen risk in technology stocks and the index will come to the U.S. stock market.

1Source: GeekWire

2Source: Business Dictionary

3Source: Siblis Research