I have written before of the benefits of diversification and the need for investors to apply a well-diversified approach to portfolio management as picking individual stocks and running a concentrated portfolio is extremely tricky.
There’s plenty of data to back up this statement, but the most informative and shocking figures come from a report published by JPMorgan (NYSE:JPM) a few months ago, which I’ve recently been able to review.
The report was put together by Michel Cembalest, the bank’s chairman of Market and Investment Strategy. It considers the benefits and drawbacks of running a concentrated portfolio, arriving at a conclusion based on the evidence pulled together by equity analysts.
The figures produce a shocking revelation, which should scare every investor away from having an extremely concentrated portfolio.
Most companies fail
The main takeaway from the report is that the data shows between 1980 and 2014 roughly 40% of all stocks in the Russell 3000 suffered permanent 70% declines from their peak values. Even adjusting for periods such as the dot-com bubble and financial crisis, these figures remain unchanged.
The Russell 3000 includes a lot of smaller companies, which have a high rate of distress in general but even outside this broad index, the number of businesses falling into distress and nearly wiping out shareholders is elevated. Indeed, the report finds that over 320 companies were deleted from the Standard & Poor's 500 for business distress reasons between 1980 and 2014. It would appear that even when investing in the world’s largest and most quoted large cap stock index, there’s no guarantee that you will make money. Further data shows the median stock returns since its inception versus an investment in the Russell 3000 in the period 1980 to 2015 were -54%. Two-thirds of all stocks underperformed vs. the Russell 3000 Index, and for 40% of all stocks, their absolute returns were negative.
But if most companies lose money for investors, why is the index heading higher? Well, it all comes down to a few key outperformers. Of the Russell 3000 stocks examined during the period of the study, 7% of the universe generated extreme returns, defined as a return of over 500% or more.
The report goes on to take a look at the role of volatility and its implications for concentrated holdings. By looking at the volatility of Russell 3000 stocks, and their returns over a three-year period, JPMorgan’s analysts find their strong correlation between rapidly rising volatility and falling returns, which is hardly surprising. Using these results the analysts then go on to try to compute what combination of each stock and the Russell 3000 would have delivered the best risk-adjusted returns. The results tell us something about the frequency with which concentrated holders would optimally choose to own different amounts of their stock if the issue of price volatility mattered to them. Across 500 observations, it made sense to be invested 100% in the concentrated stock around 6% of the time.
The rest of the time, it made no sense to hold more than 30% in a concentrated position and often none of it. Considering around two-thirds of stocks underperformed the Russell 3000 for the study, this observation makes a lot of sense.
Time to diversify
The final part of the JPMorgan report is a combination of all the three risk factors discussed above combined: the risk of catastrophic loss, the danger of underperforming the Russell 3000 and finally, the risk of heightened volatility that subjected concentrated holders with insufficient diversification to a very wild ride. The analysts find that on average 74% of concentrated investors would benefit from additional diversification based on the impact of the above factors on returns.
Put simply, if you are running a concentrated portfolio, the odds are stacked against you.
Disclosure: The author owns no stock mentioned.
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