The Math of Futility - Why Diversification Matters
There are constant temptations to try and pick stocks that will be the next big thing. However, diversification is the only strategy which ensures you will hold the stocks which drives market gains.
We received great feedback about last month’s article. Many people seemed surprised by the quoted research which showed:
Since 1926, only 4% of the total number of stocks (1,092 out of a total of 25,967) accounted for the net gain for the entire US stock market
The remaining 96% of firms that issued stock collectively produced returns equivalent to 1-month US Treasury bills over their lifetime.
Almost 60% of stocks had lifetime buy and hold returns less than the 1-month US Treasury bill return.
A US Treasury bill is regarded as a zero-risk investment, meaning most investors who picked stocks took on additional risk for no reward.
The mathematics show us it is not only hard to outperform benchmarks, but active managers - who buy only a handful of stocks - would do exceptionally well to even fight for a draw.
With the simple coin flip, you expect to call it correctly about half the time. Again, in last month’s article, we saw over 10-year periods around 75% to 90% of active managers failed to beat their benchmark, and this figure steadily increased over 15 and 20 years. As one academic asked about these fund managers, “how are so many smart people bad at their jobs?” These people aren’t necessarily losing against the market because they’re monkeys, but rather because it really is hard to beat a broad market approach to investing.
As shown above, equity market benchmarks are so reliant on gigantic gains in just a handful of stocks, that missing them – as most managers do – consigns the majority to futility. Looking at the period 1994-2008, the graph below shows the impact on returns of missing the best performing stocks in each year.
Source: Dimensional Fund Advisors[i]
A 1998 study[ii] investigated why high active manager fees didn’t solely explain the degree of consistent underperformance. They concluded the culprit was “positive skew”.
The implication was the concentration of outsized gains in a minority of index stocks is tantamount to a death sentence for anyone who gets paid to actively trade to beat a benchmark.
We’ll explain the challenge using a bag of poker chips.
Say you have 5 poker chips, 4 x $10 and 1 x $100. The five chips have an average value of $28, but what if you reach into the bag and pull out just two chips over and over? That’s roughly how active fund managers approach stocks, by picking portfolios that are subsets of the broader group. The problem with this approach is most selections will fail to snag the $100 chip.
Mathematically, there is an average value of $56 across the 10 two-chip combinations—the problem is, 6 of 10 times you’ll grab a pair with a sum of $20. The same thing happens with stocks chosen from a benchmark. Only a few managers will own the biggies, relegating the rest of the industry to mediocrity—or worse.
The ratios in the above example are a generous illustration of what happens in the market. There are thousands more combinations, and the number of outcomes that will trail the average far outnumber those that will beat it. As a result, waiting to catch the winners over time becomes an impractical strategy.
A couple of funds will manage to own the flavour of the month (or quarter, or year) and rise above the benchmark, but for most the result will be below the benchmark.
So even allowing for higher fees and expenses, if you pick random stocks rather than owning the entire market, the odds are you’ll underperform.
Stewart Partners approach of buying the market and then overweighting stocks which exhibit attributes that academic research demonstrates offer higher expected returns is, quite simply, best practice and essential to us meeting our fiduciary responsibilities to clients.
Author: Rick Walker, with thanks to the Bloomberg article, “The Math Behind Futility”, by Oliver Renick, 9 April 2017
[i] “All stocks” includes all eligible stocks in all eligible Developed and Emerging Markets at their market cap weights. Eligible stocks are required to meet a minimum market capitalisation requirement. REITs and investment companies are excluded. Compound average annual returns are computed as the compound returns of the value-weighted averages of the annual returns of the included securities. “Excluding the top 10%” and “Excluding the top 25%” are constructed similarly but exclude the respective percentages of stocks with the lowest annual returns by security count each year. Individual security data are obtained from Bloomberg, London Share Price Database, and Centre for Research in Finance. The eligible countries are: Australia, Austria, Belgium, Brazil, Canada, Chile, China, Colombia, Czech Republic, Denmark, Egypt, Finland, France, Germany, Greece, Hong Kong, Hungary, India, Indonesia, Ireland, Israel, Italy, Japan, Republic of Korea, Malaysia, Mexico, Netherlands, New Zealand, Norway, Peru, Philippines, Poland, Portugal, Russia, Singapore, South Africa, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, United Kingdom, and the United States.
[ii] “Why Active Managers Underperform the S&P 500: The Impact of Size and Skewness,” published in the inaugural issue of the Journal of Private Portfolio Management.