Why stock market diversification works

Investing in equities offers the potential for outsized returns over the long term, but several studies have shown that a surprisingly small number of stocks actually drive long term stock market returns.

This has certainly been the case lately for US equities, where in March only two stocks, Apple and Microsoft, accounted for over half of the increase in value of the S&P 500 Index, which includes 500 stocks and is generally regarded as the bellwether for the performance of the US stock market.

Furthermore, the FT recently reported that during the first quarter of 2023, almost 90% of the return for the S&P 500 was accounted for by only 20 stocks, with many of these stocks being found within the technology sector, which have benefitted from broadly falling long term interest rates and from being quite insulated from the issues within the banking sector this year.

Last year was very difficult for global equities, but over the long-term, history has shown that a diverse basket of global equities has produced an annual return in the region of 8.0%[1]. This means that an investment will roughly double every nine years.

Despite the evidence we have of how compounding at a relatively modest rate can produce excellent returns over the long term, there will always be individuals who want to speed up the compounding process by investing in a relatively small number of individual equities, in the hope of producing outsized returns. It could be argued that this is a logical endeavour given the knowledge that a small number of stocks drive market performance.

However, by investing in a concentrated portfolio, these investors run the risk of missing out on the few stocks that drive market performance, meaning they end up with distinctly below average returns.

The below chart shows that from 2000 through 2020, the median stock within the S&P returned 63% cumulatively, which is only a 2.5% annual return. This compares with the 322% return for the Index, which equates to a 7.5% annual return. The index return is being dragged up by the relatively small number of stocks (shown on the far-right hand bar) that have been able to produce outsized returns.

An investor could build a portfolio of say 20 stocks that appears diversified from a sector and industry perspective, but if they fail to select one of the few stocks that significantly outperform, they will end up with disappointing returns. This is without taking into account a behavioural problem that all of us suffer from (even if we are aware of it) called the disposition effect, which essentially causes us to sell our winners too early and keep hold of losing investments too long.

The opportunity for DIY investors has never been greater. It is possible to create a stockbroking account in minutes, with many offering low or commission-free trading and the ability to check up-to-the-minute values of their portfolio on their mobile. However, this ease of access unfortunately does not translate into superior performance, which is likely due to their portfolios being too concentrated. A study from DALBAR showed that over the same twenty-year period covered in the table above, the average US investor produced a 2.9% annual return, lagging the S&P 500 return by 4.6%[2].

University of Arizona finance professor Hendrik Bessimbinder produced further ground-breaking research on this topic. He looked at all US stocks that were traded on one of the major US exchanges over the period from 1926 to 2015 and shows that more than four in seven stocks failed to outperform Treasury bills, which is essentially the risk-free rate.

Furthermore, he shows that just 1% of stocks account for all market gains over the full period.

It turns out this is not just a US phenomenon. In fact, results are even worse outside America, according to a further Bessembinder study; all over the world, most stocks end up being money-losing investments. Fortunately, for the stocks that do not lose money, some of them do extremely well, which more than compensates for the poor investments. This is why an investment in equities has been able to outperform lower risk investments such as cash and bonds over the long term.

The implication from these studies is clear. Investors should hold well diversified portfolios and try to resist the urge to be too concentrated in a small number of companies, industries, or sectors.

The portfolios we build for clients will typically hold around twenty different funds, but these funds will give exposure to thousands of different companies. This should ensure that our clients have exposure to the few stocks that produce super-sized returns. We will consider holding an actively managed fund if the manager has a proven track record of being able to identify the stocks that do go on to outperform. We also aim to supplement the market return by taking concentrated tactical positions in certain regions or sectors, which we expect to outperform given the current market and economic environment.

[1] MSCI World Total Net Return, in USD, from December 31st 1986 until March 31st 2023 [2] Source: Quantitative Analysis of Investor Behavior by Dalbar, Inc. (2021)

Mike Evans – Head of Portfolio Management