In the last post we saw that market returns (the mean) are higher than average fund returns (the median) because the majority of mutual funds under-perform the market average. We also saw that mutual funds are packaged investment strategies, which are actively managed bets designed to beat market returns. And finally we saw that the common notion of holding multiple funds to “diversify” multiplies the odds of underperforming the market. Owning multiple bets on the market is not diversification. Winning multiple bets all at the same time is less likely than winning a single bet. No one knows the future. You can’t consistently equal or beat the market by guessing the future. Winning big once in a while is not a plan for growing wealth, it’s playing the lottery with the stock market.
Holding Lots of Individual Stocks
Today we look at a second common misunderstanding about diversification:
2). A diverse selection of twenty or fifty individual stocks is not diversification.
I once saw a popular TV host “coaching” a listener about how well the listener had diversified his portfolio of six or seven stocks across a couple industrial sectors. Gagging entertainment, maybe, but not diversification. Other gurus are on the record that owning twenty stocks is plenty—just pick twenty good ones and you’re all set. When the market is going up, finding twenty good stocks seems pretty easy. Some focus on dividend stocks—a good barometer, they say, of reliable earnings or value, or both (that’s discussion for another time).
Seems to make sense, right up until one of the twenty has a legal problem, and another has a major product problem, and still another sees a promising market—already “priced in”—stolen by a new competitor. A senior manager becomes embroiled in a scandal, and so on, the daily roll of business headlines. It might average out, it might not—hardly a reliable investment strategy to bet your retirement on. You might not lose your shirt, but you probably won’t beat the market over any length of time. If you do, the small increment may hardly be worth the effort of choosing and managing twenty or more holdings.
Owning a stock is not an investment strategy. It represents an ownership interest—an investment—in a specific company to make money over time. It’s an investment in growth of capital. When we invest in a company, we throw in with its management in that quest, and we take on the specific business risk that affects that company. Owning twenty or fifty companies does not diversify away that specific business risk—it multiplies it by the specifics of the twenty or fifty businesses we are holding. Owning a small number of stocks does not diversify away specific business risk.
If owning a small number of stocks diversified away specific business risk, then most mutual funds, which often hold a hundred or a few hundred companies, would deliver at least market returns every year. We have seen that this is not the case.* It’s too small a sample to spread—to diversify away—specific business risk.
Specific business risk is among the least rewarded of all investing risks because it involves choosing against all uncertainty which few companies out of thousands will prosper and which will not. No one knows the future and which companies will prosper or why, and which will not.
A Guess with a Bias
Owning individual stocks, whether based on reported fundamentals, chart pattern voodoo, or just a hunch, is simply a guess with a bias, a bet. Picking twenty or fifty stocks is neither diversification nor a particularly winning strategy—it’s a bet that the chosen set of specific business risk will equal or beat market returns which account for all business risk.
Holding a number of mutual funds and/or individual stocks are examples of micro-diversification. Rather than diversifying away business risk, they multiply it, making it harder to equal market returns, which exceed the returns of the average mutual fund. At the end of the day, this kind of diversification is counter-productive. Next time—The Two Free Lunches—Diversification and Compound Growth.
*No less an authority than the people who bring you the S&P500 offer this analysis: https://us.spindices.com/resource-center/thought-leadership/spiva/
S&P Indices Versus Active (SPIVA®) measures the performance of actively managed funds against their relevant S&P index benchmarks.
-The SPIVA® U.S. Mid-Year 2014 Scorecard: “The past five years have been marked by the rare combination of a remarkable rebound in domestic equity markets and a low-volatility equity environment. This combination has proven to be difficult for domestic equity managers, as over 70% of them across all capitalization and style categories failed to deliver returns higher than their respective benchmarks.”
-The Persistence Scorecard: December 2014: “An inverse relationship exists between the measurement time horizon and the ability of top-performing funds to maintain their status. It is worth noting that less than 1% of large- and mid-cap funds managed to remain in the top quartile at the end of the five-year measurement period. This figure paints a negative picture regarding the lack of long-term persistence in mutual fund returns.”