DIVERSIFIED OR CONCENTRATED?
When it comes to stock investing, investors often ask if is it better to hold a well-diversified portfolio of hundreds of stocks or a concentrated portfolio of, say, 20 or 30 stocks? The answer may not be as clear-cut as you think. Let’s look at what academic research might have to teach us.
The Case for Diversification
The essence of diversification is captured by the old adage that we shouldn’t put all of our eggs into one basket. Investing in capital markets involves the risk of loss, so we should spread our investable wealth across many securities. In support of diversification, research provides some very sobering facts about investing in stocks.
One study looked at the stocks that composed the Russell 3000 Index from 1980 to 2014. The index includes about 98% of all listed stocks in the U.S. The author found that two-thirds of all the stocks that were included in the index over those years actually underperformed the index itself. In fact, 40% of the stocks produced negative absolute returns over their life-span.¹
Another study was even more ambitious, looking at the performance of all listed stocks from July of 1926 to December of 2015, a total of almost 26,000 stocks. The author summarized his findings by writing that “the entire gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed stocks.” In fact, he found that only 86 stocks account for over half of the roughly 32 Trillion dollars in stock market wealth creation. Worse yet, he found that 58% of those 26,000 stocks returned less than one-month Treasury Bills over their life-span (The median life-span of a stock was seven years).²
We are often surprised to hear that stock returns are driven by just a handful of stocks. For example, in 2015, the S&P 500 Index returned just 1.38%. The top 10 performing stocks that year included the four so-called “FANG” tech companies, Facebook, Amazon, Netflix and Google (now known as Alphabet). According to another research piece published early in 2016, removing the impact of these 10 stocks would have reduced the index returns by 3.7% that year. The author then looked at the S&P 500 Index annual returns over a longer period, from 1995-2014, and found that the 2015 results are actually quite normal. The average performance impact of the top 10 performing stocks over that 20-year period was 4.1%.³
In summary, the implication of what we have discussed so far is that we should diversify to spread the risk of owning losing stocks while increasing our chance of owning the relatively few stocks that will survive and grow in value.
The Case for Concentration
The most obvious reason in favor of concentration is that every successful business in the world, big or small, was started by somebody who had a vision and, in many cases, were willing to risk everything. This is wealth creation as the fruit of the entrepreneurial spirit. It is the opposite of diversification and the risk of failure is high.
We call this idiosyncratic risk and finance theory says that a sufficiently diversified portfolio can eliminate almost all of the idiosyncratic risk among the different stocks in the portfolio. The risk that we are left with cannot be diversified away, and this is called market or systematic risk. The reward for bearing market risk is the equity risk premium over Treasury Bills that historically accrues to long-term stock investors. In addition to the equity risk premium, investors have historically earned additional long-term premiums for bearing the risk of owning small cap stocks, low volatility stocks or value stocks, for example. This is called factor-based investing.
In 2015, Fidelity Investments issued a research piece titled “Does the Number of Stocks in a Portfolio Influence Performance?” They analyzed the returns of U.S. large-cap equity mutual funds over the 20-year period from 1994-2014 and concluded that there was no evidence of a meaningful relationship between the number of stocks in an actively managed portfolio and its performance. They added that portfolios with either higher or lower number of holdings have beaten their benchmarks with the same success rate.⁴
Recently, research was presented at a conference sponsored by AQR Capital Management which compared these two approaches to equity investing. The first was called Quantitative, characterized by well diversified, rules-based, systematic, factor-based investment approach, designed to capture various market and factor risk premia. The second was called Fundamental, which relied on individual stock managers using a “Best Ideas”, thematic approach to managing concentrated portfolios, designed to capture more idiosyncratic sources of return, such as mispriced stocks.
They compared the investment performance of the top 25% of U.S. large-cap core managers, both Quantitative and Fundamental, from December of 2000 to December of 2015. They concluded that both groups had identical excess returns after fees of 1.7% per year and that combining the two approaches could actually improve the risk-adjusted returns versus using just one of the approaches alone.⁵
We conclude, therefore, that there are advantages to using both a diversified and a concentrated approach to investing in equities. At Coyle Financial Counsel, we utilize a “Core and Satellite” investment process to capitalize on this idea. We use a well-diversified, quantitative, factor-based approach for our core portfolios while using certain concentrated “Satellite” stock managers who seek to outperform using a fundamental, “Best Ideas” approach. We believe that this combination will help our clients achieve their long term financial objectives.
John G. Finley, CFA
May 18, 2017
- “The Agony & The Ecstasy: The Risks and Rewards of a Concentrated Stock Position”, by Michael Cembalest, J.P. Morgan Asset Management (“Eye On The Market”, J.P. Morgan, 2014)
- “Do Stocks Outperform Treasury Bills?”, by Hendrik Bessembinder, Dept. of Finance, W.P. Carey School of Business, Arizona State University, Draft: February, 2017, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2900447 (Accessed 5/8/2017)
- “SNAFU: Situation Normal, All-FANGed Up”, Cliff Asness, AQR Capital Management (1/11/16), https://www.aqr.com/cliffs-perspective/snafu-situation-normal-all-fanged-up (Accessed 3/13/17)
- “Does the Number of Stocks in a Portfolio Influence Performance?” by Michael Hickey, CFA, et al, Fidelity Investments (Leadership Series / Investment Insight, FMR LLC, 2015)
- Author’s notes from attending AQR University Event, Chicago, Illinois, May 9, 2017, Sponsored by AQR Capital Management