Let's rewind to the start of this decade. If you had to choose one stock through the decade for the best returns, would you have bought the cutting edge tech titans (Apple, Google, Amazon) or a company that delivers greasy pizza to your neighborhood at discount prices?
Stock picking is a guessing game
Your gut should be used to pick the food you eat; not the stocks you buy. A humble pizza company has generated more than twice the returns of most high-flying tech companies since 2010. What are the chances you would have picked a low tech commoditised pizza company in the past decade? Probably slim to none.
Trying to identify the next Domino's or a group of future winners is a guessing game. By trying to outguess the market and pick a concentrated number of 'winning' stocks, you're in fact significantly increasing the likelihood of missing out on the top performers.
Returns in an index are concentrated on the top performing stocks
The fact is that the bulk of the returns of any index is concentrated in just a handful of stocks that generate a disproportionate amount of overall market gains.
This is what is known as positive skew in the distribution of returns in the market. It is one of the major headwinds to stock-picking. So many active fund managers fail to beat the benchmark because of a simple reason - the absolute number of stocks that beat the benchmark is few and most stocks perform far below the average. This is before the costs involved in stock-picking or high fees you pay active managers for their services.
Diversification improve the odds of holding the best performers. In a study done by Dimensional Fund Advisors, a portfolio of all global stocks returned 7.3% per year from 1994 to 2016, . But if you missed out on the best performing 10% of stocks, the return declines to 2.9%. If you missed out on the best performing 25%, the return drops to -5.2%.
We're not saying that stock picking is a worthless endeavour, but the normal investor starts at a disadvantage. Heaton, Polson and Witte published a paper explaining the math behind why active management is challenging. They distilled their argument into this illustration:
You have five poker chips, four worth $10 and one worth $100.
If you pull one chip out, the average expected value is $28
If you pull two chips out, it the average value is $56.
But most of our choices will fail to get the $100 chip and in fact...
6 out of 10 times you'll grab a pair with the lowest sum of $20.
This is similar to active stock-picking: most fund managers will miss the high-performing $100 stock, which consigns them to underperforming the benchmark. We can help improve the chances of capturing the market returns through diversification. (Source: The math behind futility, Bloomberg)
We all want to be the star fund manager that discovers the next Domino's Pizza, but even picking it once does not guarantee that you can replicate your success. Holding a diversified portfolio will ensure that you are well-positioned to capture returns wherever they occur in the market. You can have your pizza and eat it too.