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Why Diversification Beats Conviction (Part 2)

The more concentrated a portfolio is, the greater the risk of missing out on the market's biggest winners and underperforming.

Alex Bryan 20.12.2018

In part 1 of this article, we set the scene by looking at how stock returns drove market returns. In this part of the article, we will look at how diversification comes into the discussion.

Why does all this matter? It suggests that investing in a concentrated portfolio is a bad idea because the opportunity cost of missing the market's big winners exceeds the benefits of avoiding the (many) losers. Bessembinder directly illustrates this point in his study. He created market-cap-weighted stock portfolios of varying sizes chosen at random each month and measured the performance of those strategies over a few horizons. In these simulations, the risk of under­performing over a decade fell to 52% from 59% as the number of stocks included in the portfolio increased to 100 from five.

While no one selects stocks at random, these results are consistent with the experience of active mutual fund managers over the past decade. To arrive at this finding, I grouped all active mutual fund managers (including nonsurviving funds) in the large-blend Morningstar Category into quartiles based on the percentage of assets invested in their top 10 holdings at the end of June each year from 2008 through 2017. I then tracked the average performance of the funds in each quartile over the next 12 months and strung the returns together over the full decade. I repeated this process for the mid- and small-blend categories. The results are shown in Exhibit 2 ("Q1" represents the quartile of most concentrated funds).

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA is the Director of Passive Fund Research with Morningstar.

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