Traditionally, when we discuss the concept of a highly concentrated portfolio, we talk about risk. As we know, putting all of your eggs in one basket means a single mistake can be very devastating. What is often less emphasized is how a concentrated portfolio will most likely underperform a diversified portfolio over time, and how this can negatively impact an investor’s financial goals.
How can we say that a concentrated portfolio will most likely underperform? After all, we don’t have a crystal ball and certainly can’t predict the future. What we do have is data and research which can give us insights into past performance. The research we’d like to share today comes from Hendrick Bessembinder, Professor of Finance at Arizona State University. His recently published paper “Do Stocks Outperform Treasury Bills?” comes to the surprising conclusion of: ‘yes.’ Dr. Bessembinder’s research shows us that, “the entire gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed stocks.” So while the stock market as a whole has significantly outperformed T-Bills, the source of that outperformance was the small number of stocks that achieved tremendous gains. He goes on to conclude, “The results also help to explain why active strategies, which tend to be poorly diversified, most often underperform.” Note, this one is a lengthy paper, for those interested in some substantial depth on the topic.
If the majority of lifetime wealth creation in the stock market is attributable to a small number of public companies, then an investor needs to make sure they own those stocks in their portfolio. Holding a concentrated portfolio carries with it the risk that an investor will miss out on these great performers, and experience little to no growth in their portfolio over time. This growth is essential for achieving financial goals and maintaining the purchasing power of those assets. So, while a concentrated portfolio often sets off alarm bells in our heads regarding risk, perhaps we should be paying more attention to the implications on returns as well.