If diversification is a free lunch, use the full buffet.
In a recent article that highlighted the perils of owning individual stocks, I offered the historical evidence demonstrating how only a small percentage of stocks have accounted for all the gains provided by the market—with the vast majority earning a big, fat zero in aggregate cumulative returns, even before considering the impact of inflation or taxes.
The article included a study by Longboard Asset Management called “The Capitalism Distribution,” which covered the period 1983 through 2006. Longboard recently updated the study, so I thought I would share its findings, which serve to reinforce the risky nature of owning individual stocks.
The new study covers the period 1989 through 2015 and a total of 14,500 stocks. Over this period, the S&P 500 Index returned 10.0% and provided a cumulative return of 1,324%. The broader Russell 3000 Index produced almost identical results. It returned 10.1% per year and provided a cumulative return of 1,341%.
The following are some of the study’s important findings—findings that demonstrate just how risky investing in individual stocks, and a failure to diversify, really is:
Despite these miserable odds—with only 20% of stocks providing 100% of the returns—investors who broadly diversified through passively managed index funds earned roughly 10% per year (less low costs) and a total return of more than 1,300%. That occurred because most indices are market capitalization weighted.
Successful companies with rising stock prices carry larger weightings in the index. Likewise, unsuccessful companies with declining stock prices receive smaller weightings. Companies showing continued declines are eventually delisted to make way for growing companies.
So, despite the fact that the average (mean) annualized return for all stocks on the S&P 500 Index is negative, the index can still deliver an overall positive rate of return.
Why Diversification Matters
The research, as cited in the aforementioned June 2017 post, shows that most common stocks (more than four out of every seven) do not outperform even virtually riskless one-month Treasury bills over their lifetimes.
The research also shows that individual stock returns exhibit a high degree of positive skewness (lotterylike distributions), meaning a very small percentage of outperforming stocks account for the large majority of returns.
For example, one study that covered the 90-year period ending in 2015 found that 96% of stocks just match the return of riskless one-month Treasury bills. The implication is striking: While there has been a large equity risk premium available to investors, a vast majority of stocks have earned negative risk premiums.
The study’s finding demonstrates just how great the uncompensated risk is that investors who buy individual stocks, or a small number of them, accept—risks that can be diversified away without reducing expected returns.
Such evidence highlights the important role of portfolio diversification. Diversification has been said to be the only free lunch in investing. Unfortunately, most investors fail to use the full buffet available to them.
This commentary originally appeared August 14 on ETF.com
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