Diversification, and the benefits thereof, is something I have written about multiple times before. Recently, however, I have discovered two pieces of data that really highlight how important diversification is to a well-rounded investment strategy. The numbers are enough to terrify even the most devoted, concentrated investor.
Time to diversify?
The world’s most well-known investors are all recognized for their love of concentrated stock portfolios. Several have even remarked that diversification is a waste of time and the only way to make money in the market is to have a concentrated equity portfolio. This is all well and good, but it is really not suitable advice for the average investor.
The most famous investing gurus got where they are today by being good investors, but that is not to say there was not a degree of luck involved as well.
What would have happened to Warren Buffett (Trades, Portfolio) if his American Express (AXP, Financial) investment had not worked out and the Salad Oil scandal had taken down the company? Or if Coca-Cola (KO, Financial) was hit with such a massive bout of negative publicity it could never recover? If either of these scenarios unfolded, Buffett would not be where he is today.
To give another example, what would have happened to Carl Icahn (Trades, Portfolio) if lawmakers had viewed his actions at TWA as criminal and thrown him in jail?
There are certainly cases where this has happened, but because the ranks of the world’s most famous investors are stalked by survivorship bias, it is difficult to realize that for every one Buffett there are tens of thousands of failed investors.
That is why diversification is so important and critical for long-term investing success.
Numbers don’t lie
Research by Arizona State University finance professor Hendrik Bessembinder shows exactly why this is the case. To try and figure out the average return of single stocks over the long term, he studied the returns of 26,000 equities over the period of 1926 to 2015. Over this nine-decade period, equities created $31.8 trillion of wealth. The shocking thing is that all of this wealth was generated by just 4% of equities; 96% of stocks achieved nothing. Including inflation, the real return on 96% of the universe was actually negative. To put it another way, the average investor has a one in 24 chance of picking a stock that will generate positive returns over the long term. ExxonMobil (XOM, Financial) alone accounted for 3% of the wealth created over the period and Apple (AAPL, Financial) accounted for about 2%.
These findings are only reinforced by a report issued by JPMorgan last year. According to the report, titled “The Agony & Ecstasy: The Risks And Rewards Of A Concentrated Stock Position,” the return on the median stock since its inception versus an investment in the Russell 3000 Index is -54%.
Furthermore, since 1980, 320 companies have been removed from the S&P 500 due to reasons of "distress." So, during the past three-and-a-half decades, 64% of the index has been turned over. Based on these figures, JPMorgan calculates the chance of actually finding an extreme winner is just 7%. Since the 1980s, 40% of all companies experienced a severe loss and never recovered.
The bottom line
Diversification is not a bad strategy. Some of the world’s most famous investors may advocate concentrated portfolios, but as the figures above show, you have to be very lucky to correctly pick a stock that produces positive returns over the long term. The chances of picking a winner are so low it is hard to justify even trying. That is possibly why Buffett advocates an index tracker fund for most investors -- the risk of picking the wrong stock and losing money over the long term is just too high!.
Disclosure: The author owns no stock mentioned.
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