TRIVIA TIME: how many stocks make up the Wilshire 5000 Total Market Index (a widely used benchmark for the U.S. equity market)?
While the logical guess might be 5,000, the reality is that as of December 31, 2016, the index actually included around 3,600 companies. In fact, the last time this index contained 5,000 or more companies was at the end of 2005.1 Surprisingly to most, this reduction in investable companies is nothing new. Over the past two decades, there has been a steep decline in the number of U.S.-listed, publicly traded companies. With this information in mind, some natural questions may arise. Questions such as: should investors in public markets be worried about this change? And, does this reduction mean that it is more difficult to achieve a truly diversified stock portfolio? Fortunately, the answer to these questions is no. In fact, when viewed through a total world lens, a very different story begins to emerge.
While it is true that in the U.S. there are fewer publicly listed firms today than there were in the mid-1990s (a decrease of about 2,500), there is no consensus about why listings have decreased over this period of time. As with many unsolved questions, a number of academic studies have explored possible reasons for this change. One line of investigation considered if changes in the regulatory environment for listed companies in the U.S. relative to other countries may explain why there are fewer listed firms. Another examined whether the change has been driven by the possibility that small private companies have been acquired more often by larger established firms already listed on the exchanges, rather than go through the IPO process themselves.
Regardless of the reason why it’s happening, the good news to investors is that it’s not actually limiting their ability to gain access to a diversified stock portfolio. The number of firms listed on all global equity market exchanges – U.S., non-U.S. developed, and emerging markets – has increased from about 23,000 in 1995 to 33,000 at the end of 2016, as illustrated in Chart 1 below. As you can see, it is clear that the increase in listings both in international developed markets and in emerging markets has more than offset the decline in U.S. listings — that is, the number of publicly listed companies around the world has increased, not decreased.
Although this number is substantially larger than what most investors might consider to be an investable universe of stocks, it’s important to use as a baseline to define “the market.” Because we don’t want to take on unnecessary risks of buying illiquid companies or ones without a viable market in which they trade, only stocks that trade freely and meet reasonable standards for liquidity are deemed investable. With these filters, the portfolios that we build for our clients currently contain around 13,000 stocks. This is a substantially larger number than is contained in the MSCI All Country World Index Investable Market Index (MSCI ACWI IMI). This widely used global index which is often the main benchmark to globally allocated portfolios, only contains between 8,000 and 9,000 stocks.2 It’s through our additional screening and fund searches that we’re able to implement with tools that allow us to hit the higher mark.
So, why do we need to be so diversified? Some investing textbooks claim that a portfolio of ten to fifteen stocks is sufficient to be adequately diversified. Under that assumption, one of the most widely quoted stock indexes, the Dow Jones Industrial Average, should be more than adequately diversified at thirty stocks. Shouldn’t 9,000 be enough? As with most questions in economics, the answer is simply, “it depends.” We know through empirical economic research and mathematical simulations that the number of stocks held in a portfolio dramatically impacts the likelihood that a portfolio will perform as designed and expected. It’s long been understood that if you’re willing to accept a much higher likelihood of underperformance in the hopes of being like the lucky lotto winner holding the one winning ticket, then you should concentrate your holdings in a few stocks. If not, by diversifying your portfolio to its fullest extent you reduce the likelihood of a negative surprise as you experience returns over time. As with many long-standing, commonly held rules of thumb, this one may be on the chopping block.
In a recent study by Dimensional Fund Advisors, portfolios with various levels of diversification were analyzed to see how an increase in the number of stocks held in portfolios impacted their likelihood of outperformance.3 As you can see in the chart [below], they found a clear and consistent relationship between the number of stocks held in a portfolio and the likelihood of a portfolio outperforming its benchmark in both the short and long term. Diversification may not only reduce risk but may also increase the likelihood of the greatest financial success.
We also know that by having as broadly diversified a portfolio as possible, it is better suited to address risks that fall outside of the performance of just the underlying stocks. By owning stocks in the roughly fifty countries that CCM portfolios have exposure to, you reduce the risks that currency movements can pose—beyond the value of the underlying holdings. In 2016, the strengthening dollar hindered the returns of most international stocks even though the companies fared well. So far this year the dollar has weakened, which provides a benefit to U.S. investors with assets invested abroad.4 With a diversified portfolio, we also see a reduction in unnecessary turnover, allowing for patient trading strategies to be employed. This helps to a) reduce transaction costs, and b) avoid potential tax liabilities which keeps money in the portfolio and out of others’ hands.
The increased number of publicly traded companies over the past twenty years is a positive development for global investors. Increasing the number of companies available for investment benefits you by allowing for additional diversification as well as potentially improved performance. Normally we might think that too much of a good thing will turn out to be bad for us, but in the case of diversification that just isn’t so. Kenneth French, Professor of Finance at the Tuck School of Business at Dartmouth College, and Dimensional Fund Advisors Director and Consultant, sums up the role of diversification in saying, “Diversification is about the closest thing to a free lunch in capital markets, so you may as well get a huge helping of it.”
3. Dimensional, “How Diversification Impacts the Reliability of Outcomes,” January 2017. Available here.
4. JP Morgan, “Guide to the Markets,” March 31, 2017, p. 42.