Some financial advisors advocate for concentrated “best ideas” portfolios as the surest path to market outperformance. Who doesn’t want that? The premise is when a portfolio consists only of a manager’s best ideas, returns are undiluted by second best or lesser ideas — but the reality is very different. Because we prefer probabilistic thinking over stories, we turn to empirical evidence to stress test anecdotes and narratives.
Empirical evidence has demonstrated that increasing investment concentration doesn’t raise the odds of outperformance; it lowers them. The less diversified a portfolio, the less likely it is to hold the small percentage of stocks that account for most of the market’s long-term return.
People underestimate how few stocks drive nearly all of the investment return of an index. A relatively small number of excellent performers has a disproportionate influence on the market’s overall return.
J.P. Morgan Asset Management published the distribution of returns for the Russell 3000 from 1980 to 2014. Forty percent of all Russell 3000 stock components lost at least 70% of their value and never recovered. Effectively all of the index’s overall returns came from 7% of components.
Most stocks don’t deliver above-average investment returns. According to S&P Dow Jones Indices, only 22% of the stocks in the S&P 500 outperformed the index itself from 2000 to 2020.
“When a randomly chosen stock has roughly one chance in five of beating an index fund, successful stock selection is very difficult,” Craig Lazzara, managing director at S&P Dow Jones Indices, wrote earlier this year. Between 2000 to 2020, the S&P 500 gained 322% while the median stock rose by just 63%.
Concentration can increase the odds of earning high margins of outperformance, but the probability of missing that return target increases more quickly than the probability of reaching it. For an active manager to make economic predictions that add value to a portfolio, they must have excess returns that exceed the benchmark after their higher management fee. Research has concluded that excess investment returns decrease with increased investment holdings.
Additionally, the “success rate” is a measure of the manager’s ability to identify outperformers. Interestingly, the “success rate” necessary for a portfolio to outperform decreases as the number of holdings increases. That empirical truth doesn’t support the narrative of a “best ideas” portfolio with more concentrated stock picks.
Jack Bogle put it simply when he said, “Don’t look for the needle in the haystack. Just buy the haystack.”
In summary, at Delap Wealth Advisory, our investment beliefs favor humble forecasts and bold diversification. We’re humble, evidence-based asset allocators that have an appreciation for history while respecting its limitations. We understand that while we can’t predict the future, we can prepare for many possibilities.
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