In part 1 of this article, we set the scene by looking at how stock returns drove market returns. In this part of the article, we will look at how diversification comes into the discussion.
Why does all this matter? It suggests that investing in a concentrated portfolio is a bad idea because the opportunity cost of missing the market's big winners exceeds the benefits of avoiding the (many) losers. Bessembinder directly illustrates this point in his study. He created market-cap-weighted stock portfolios of varying sizes chosen at random each month and measured the performance of those strategies over a few horizons. In these simulations, the risk of underperforming over a decade fell to 52% from 59% as the number of stocks included in the portfolio increased to 100 from five.
While no one selects stocks at random, these results are consistent with the experience of active mutual fund managers over the past decade. To arrive at this finding, I grouped all active mutual fund managers (including nonsurviving funds) in the large-blend Morningstar Category into quartiles based on the percentage of assets invested in their top 10 holdings at the end of June each year from 2008 through 2017. I then tracked the average performance of the funds in each quartile over the next 12 months and strung the returns together over the full decade. I repeated this process for the mid- and small-blend categories. The results are shown in Exhibit 2 ("Q1" represents the quartile of most concentrated funds).
The data is clear: The more concentrated a portfolio is, the greater the risk of missing out on the market's biggest winners and underperforming. This risk is greater among mid- and small-cap stocks than it is among large ones. It is hard to identify the market's big winners ahead of time, and more difficult still for a concentrated manager to ride those stocks all the way up because doing so would eliminate any semblance of diversification. It is also difficult to hold on to winners because their valuations likely become stretched along the way, which may tempt managers to sell to lock in the gains and invest in a more attractively valued alternative.
But if being too concentrated is a sin, so is investing in a benchmark-hugging portfolio with high fees. It is difficult for managers that don't stray far from their index to recoup their fees. Diversification doesn't require limiting active risk, but rather casting a wide net to improve the odds of picking up the market's big winners and limit the impact of individual stock investments if they go wrong.
Broad Indexes Are a Good Starting Point
Broad market-cap-weighted index portfolios, benefit from the positive skew in stock returns because they don't miss the big winners and they ride them all the way up. Usually, these index funds do a decent job diversifying risk, though they can load up on certain sectors or regions from time to time. And they have limited exposure to the smallest names in the market, so it's possible to construct an even better-diversified portfolio.
While most stocks will likely underperform the market, deviating from the broad market-cap-weighted portfolio doesn't preclude success. For instance, the equal-weighted version of the U.S. stock market portfolio has been even tougher to beat, likely because it benefited more from the greater positive skew in returns among smaller stocks. There are also other ways to outperform.
It is no secret that stocks with certain characteristics like small size, low valuations, high profitability, and strong recent returns (momentum) have tended to offer higher returns than the market over the long term, and they will likely continue to do so. Tilting toward these stocks can help boost expected returns. But it is still important to stay diversified to reduce the risk of missing the big winners, which have a disproportionate impact on the returns to each investment style (factor).