“Bing!”—your iPhone alarm wakes you up and you drag your feet to the kitchen for a cup of coffee. Coffee in hand, you scroll through Facebook when the doorbell rings—it’s that Amazon package you ordered yesterday. You log in to Microsoft to check your emails and your calendar reminds you of the multiple video calls you have this morning. “What will the weather be like today?” you ask Google.

Is this an exaggerated morning routine? Maybe. But, not unrealistic for many households. The “Big Five” tech companies, Apple, Facebook, Amazon, Microsoft and Alphabet (aka Google), play a significant role in society today and many of us can relate to using these products and services daily.

Amidst COVID-19, the use of these products and services has increased. In fact, following the March 2020 market crash, many investors speculated on investment opportunities that higher usage of “Big Five” tech products could present. This speculation was not unfounded, but potential volatility usually shadows the expectations of higher returns.

How do the markets define technology companies?

Standard & Poors (S&P), a major market index provider, tracks some of the largest to smallest companies in the United States, and groups them into sectors such as technology, energy, materials, and industrials. The simplicity of grouping indexes into sectors allows investors to understand at a broader level how each sector performs. It may be a surprise that companies invested in technology funds may not fit the formal definition provided by these major index providers. Amazon for example is not technically classified as a tech company by the S&P (it is classified as consumer discretionary), but it is lumped in with the Big Five in technology funds due to the nature of its innovation and e-commerce interactions between businesses and customers.

The definition of a tech company will continue to evolve as the role technology plays overlaps, as technology can assist in the facilitation of products and services in other market sectors. For example, Uber is grouped into the transportation industry but uses technology to offer its services. The same could be said about investment advice offered by a robo-advisor in the financial sector, where the service platform itself is rooted in technology. How we view technology companies will continue to change and take on broader meaning than the formal definitions by major index providers, and this has likely bolstered both market return and volatility in the S&P 500.

How big is “Big Tech”, anyway?

The United States has some of the most prolific technology companies in the world, but oftentimes when you read about the American technology sector in the financial press, they are referring to the Big Five. This is because these five companies make up approximately 25% of the S&P 500 - a broad market index commonly used as a proxy for the strength of the US equity market. This large weighting heavily influences the return profile of the index as a result.

The Big Five make up such a large portion of the S&P 500 because this particular index is market capitalization weighted. Market capitalization is determined by multiplying a company’s stock price by the amount of shares of the company stock that are outstanding; as the price of the stock increases, the market capitalization increases, which further increases their overall position, or prescribed weight in the index. The larger the position in the index, the more influence the returns of a company will have on the overall return of the index. Because the Big Five represent approximately a quarter of the index, changes in their stock prices impact the overall index significantly and this can make for flashy headlines that bring more attention towards the sector and individual technology companies.

We can also look at the S&P 500 on an equal weighted basis, meaning all companies in the index are given equal weight and therefore a dramatic increase in a single company’s stock price would not increase the company’s weight in the index. Comparing the two weighting methodologies provides interesting insight as to the impact that heavily weighted companies can have on an index’s performance and its popularity. When we look at the equally-weighted index represented by the blue line below versus the S&P 500 orange line, we see that both versions of the index declined rapidly in March 2020 but the market capitalization weighted index not only outperformed the equal weighted index but also grew to higher levels by the end of September. The return difference between the indexes was 10% (3.6% versus -6.4% for the equally-weighted index). This chart therefore corroborates the idea that the highly weighted Big Tech companies make a significant contribution to the overall returns of the S&P 500.

What is driving US technology sector returns in 2020?

It cannot be understated how great of an impact trading behaviour (what investors choose to buy and sell and why they make their choices) can have on financial markets. Indeed, there is little doubt that emotions and human behaviour are contributing factors to return volatility in the US tech sector in 2020. Trading behaviour and emotions can result from mental shortcuts (heuristics) and cognitive biases, and in some cases, can negatively influence an investor’s decisions. While mental shortcuts can be efficient tools for decision-making in our daily lives, deeply ingrained emotional and cognitive patterns can, when unchecked, lead to potentially detrimental investment decisions.

While fully recognizing that many technology companies were well positioned to profit from a COVID-19 lifestyle change and the convenience of their product and service offerings, the sharp market drop and subsequent rebound in the sector may warrant further analysis by investors so they can assess potential emotions and human behaviour guiding market participants’ actions. This is not to say that technology companies are over or undervalued in the current market environment; keeping a pulse on mental shortcuts and emotions which could be driving tech market value will allow an investor to make a more informed portfolio management decision.

There are noteworthy biases that can show up within investor behaviours, not just within technology, but in markets overall: trend-chasing (also known as herding), overconfidence, and confirmation bias.

Overconfidence and trend-chasing may play a part in market trends such as those seen in the technology sector following the steep 31% return drop that was witnessed in March 2020 (chart below). Trend-chasing (herding) implies that investors have a strong drive to follow the crowd, and in a sector as popular and visible as technology, investors can feel immense pressure to “not miss out” on what they think has potential to be a huge opportunity for growth.

Overconfidence is an emotional bias exhibited by investors who hold the mistaken belief that they know more about an investment than they truly do. Experts and novices alike have shown to overestimate their skills in their ability to make successful investment choices.

There is a knock-on bias associated with overconfidence, known as confirmation bias, or the tendency to seek out and favour the information which supports our pre-existing beliefs.

The combination of these two cause many failures in decision-making, as investors with inflated ideas of their knowledge and skills often fail to integrate dissenting or opposing views, even when evidence would indicate its strength. Think of reading a favourable analyst's report on a favourite high-profile tech stock, while ignoring the four additional contrary recommendations about the same investment, and continuing to hold the belief that you know you’ve got it made. Research suggests that stronger confirmation bias bolsters overconfidence and detriments investing performance.

Trend-chasing may be one of the strongest biases within investing and trading behaviour. Despite knowing that past performance does not necessarily predict future results, investors have a strong drive to follow the crowd. This herd may be led by notable/influential investors, or by the buzz of financial press coverage around particular investments, leading investors to make an investment decision they might not have independently come to. If left unchecked and taken to an extreme, trend-chasing behaviour can result in overvaluation, eventual market bubbles, and potential subsequent collapses.

The understanding and awareness of our own investor behaviour and potential behavioural pitfalls is the first step in improving financial decision-making and staying on track towards long-term financial goals. In addressing and discussing these biases with a trusted advisor, you may come up with a financial plan that is easier to stick to and inherently less prone to bias, as well as better aligned with your financial goals. We can also avoid some of these pitfalls and get more comfortable with investing in tech by consciously checking the facts. This includes collecting, analyzing, and intentionally integrating information that goes against our currently held beliefs and gut reactions, to make a truly informed decision. We also want to be as objective as possible when tracking our decision-making, and measuring the outcomes of our choices. Keeping a journal of trading decisions to review over the long-term can help with this.

Is investing in tech the ticket to investment success?

Tech is here to stay, and the rapid advancements that have been further expedited by COVID-19 are, too. We know companies will continue to innovate and utilize new technologies to facilitate product and service offerings, but what role do they play in an investor’s portfolio?

As an investor, sector diversification is just as important as diversification by geography or by individual companies. While a professional money manager looks to create a portfolio which is well-diversified between Canadian, US and International markets, it is perhaps equally important to professional investment managers that the fund is providing investors with a consistent return that is aligned with their risk tolerance over the long term, rather than make big wins from one particular sector. By looking at the historical performance of the technology sector in the US, we can see that the “best” and “worst” performing sectors have varied over the years. From 2005-2019 the technology sector was the best performer in 3 of those 15 years.

Hindsight is always going to be as clear as the table above, but foresight is inevitably very clouded. Because it is almost impossible to guess which individual geographic sector, economic sector or individual stock is going to be the next market darling—or bumpkin—it is crucial to diversify your investments and understand that overconfidence in an industry can be fueled by our daily interactions with it. Like in any industry, if you do choose to make a speculative tech bet, identify your biases first and consider the size of the speculative investment in the context of your overall plan.