July 12, 2018

Diversification: It’s about more than risk control

“Diversify your portfolio!” implored the well-meaning investment advisor. Over the years, you have likely heard this phrase many times and from many sources, including me. ‘Diversification’ has been drilled into the head of many an investor and for good reason: Diversification[1] is, in fact, a critical concept in investing.

Interestingly though, the standard reasoning for why diversification is so important is only half the story. Generally, investors are encouraged to diversify their portfolio as a means of risk control. For example, if you own many stocks, rather than just a handful, you won’t suffer too much if you happen to own the next Enron. That’s a very good reason to diversify but it’s not the whole story. Describing the merits of diversification this way also runs the risk of implying that diversification is a conservative investment approach while a concentrated approach might be described as an aggressive but otherwise reasonable one.

A recent paper[2] by Arizona State University professor Hendrik Bessembinder underscores the concept that diversification is more important than simply a method of risk control. According to Bessembinder, out of 25,300 companies in the Center for Research on Securities Prices (CRSP) database since 1926, “the 1,092 top-performing companies, slightly more than 4% of the total, account for all of the net wealth creation. That is, the remaining 96% of companies whose common stock has appeared in the CRSP data collectively generate lifetime dollar gains that matched gains on one-month Treasury bills.”

The market’s impressive overall returns over time are the result of a very small number of stocks that do exceedingly well. And the vast majority — 96%, according to Bessembinder — of stock returns range from mediocre to terrible.

The implications of this are startling for those who pursue concentrated portfolios of individual stocks.  The results suggest that unless you are an exceptionally good (lucky) stock picker, you are almost certain to underperform the market by missing out on the very few best individual stocks in the market.

For those willing to pursue an evidence-based approach to investing, you can ensure capturing the market return, not by finding the proverbial needle in the haystack, but by buying the haystack.


[1] A quick side note here, in referring to diversification, I am describing the idea that, for example, when constructing the U.S. stock component of a portfolio, rather than owning a half dozen individual U.S. stocks, you might own broad market mutual funds that hold thousands of U.S. stocks.

[2] Hendrik Bessembinder – Department of Finance, W.P. Carey School of Business, Arizona State University, May 2018 “Do Stocks Outperform Treasury bills?”