J.P. Morgan conducted an analysis on the Russell 3000 Index to determine the frequency of catastrophic losses1. This Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market.
The index had an impressive run from 1980-2014, increasing over 1,800% (just over 9% annually), yet this report derived three surprising conclusions:
- Catastrophic Losses: Roughly 40% of all stocks in the index suffered a permanent 70%+ decline from their peak value. The numbers were much higher for technology, biotech and metals & mining.
- More Losers Than Winners: Two-thirds of all stocks underperformed the index, and the absolute returns for 40% of all stocks were negative.
Bad Average: The return on the median stock since its inception versus an investment in the index was -54%.
These conclusions appear to contradict such stellar performance of the overall index. How can an index average over 9% annually for 34 years when most of the individual stocks performed so poorly?
The answer lies in the chart below. The blue bars indicate the number of stocks that either outperformed or underperformed the broader index and by how much.
For example, the number of stocks in the Russell 3000 Index that outperformed by greater than 50% is just over 600. The number that outperformed by greater than 100% is around 450 (halfway between the 300 and 600 markers on the vertical axis).
The red-dotted line is the median return. Notice that it is slightly to the left of the blue bar that indicates over 1,500 stocks underperformed by 50% or more (supporting the third conclusion above).
The reason why the Russell 3000 Index has performed so well despite most stocks underperforming has to do with the blue bars to the right of the green line. These are the home runs investors dream of owning.
However, these winners only represent 7% of all stocks in the sample. It’s crazy to think that so few stocks are responsible for driving such strong returns until the math behind winners and losers is considered.
A stock has a limit to how much money it can lose, but there is theoretically no cap on the upside. Imagine an investor putting $100 into 10 stocks for a total investment of $1,000. If 8 go to zero, one doubles, and another rises ten-fold, the total return would be 20%. Not too bad considering 80% of the portfolio delivered goose eggs.
Simply put, for every home run that drove the Russell 3000 Index higher, there were way more stocks that negatively impacted its overall performance.
Don’t Concentrate Too Much
This report clearly indicates that some stocks massively outperform the broader market over the long run. Any investor who was skilled at finding these companies before they took off and patiently held them could crush most benchmarks.
There is a large cohort of active managers who attempt to do just that – build a concentrated portfolio of a handful of stocks that are expected to fall to the right of that green line. These are often brilliant individuals that work 100-hour work weeks and spend millions to access information to help them find that 7% of stocks.
However, the odds are stacked against them because executing such a strategy consistently is extremely difficult. Even the most successful investor is lucky to find a handful of home runs in a lifetime.
Making matters worse, if any given stock has a 40% chance of experiencing a permanent loss of 70% or greater from their peak value, then being wrong can wreak havoc on a portfolio. The best way to manage such risk is to avoid concentrated holdings so that a single catastrophic loss does not take the entire ship down.
No matter how much conviction one may have about an investment opportunity, diversification demands prudence. Investing to build net worth over time is a process of managing risk, not taking too much risk, and concentrated positions should be avoided whenever possible.
Each investor is unique, so it’s tough to generalize about where the concentration becomes too high. But it’s hard to imagine a situation where a single investment should ever comprise more than 20% of an individual’s investable assets (excluding a primary residence).
The Bottom Line
Imagine a world where it was possible to build a portfolio that only held home runs and avoided the other 93% of the stock market. An investor could build the perfect allocation by noon, drive to the golf course without hitting a red light, shoot 20-under par (avoiding all sand traps), drive home (again no red lights), and then cook the perfect meal for the family without over-salting any of the food.
The problem is the real world is governed by statistics and uncertainty, and crystal balls are hard to come by. The odds of finding the next Amazon are so incredibly small that an investor can often do more harm than good by searching for it.
Fortunately, we don’t need to live in a perfect world to meet our financial goals. Not only is swinging for home runs dangerous, but there is also little reason to try. After incorporating the issue of single stock volatility, the report found that 75% of all concentrated holders would have benefited from some amount of diversification. Meaning, owning a lot of losers is ok because the catastrophic losses should not matter as long as we remember three important rules:
- Remain Diversified: A diversified portfolio can improve the odds of finding home runs and mitigate concentration risk.
- Ignore The Pawns: Don’t lose focus when stocks tank. In a well-diversified portfolio, these are merely the pawns that must exist to find the home runs.
- Swallow Your Pride: Most successful investors would rather be rich than right, and they got there by becoming comfortable with being wrong a lot.
The bottom line is to focus on the overall portfolio performance rather than the individual components. Catastrophic losses will most likely not be catastrophic to your financial future unless you let them.
1 The Agony & The Ecstasy – The Risks and Rewards of A Concentrated Stock Position, J.P. Morgan 2014
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. Richard W. Paul & Associates does not provide tax, legal, investment, or accounting advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.