Diversification is Also About Capturing Returns (And a little about Tech Concentration in Market Indexes)

Not too long ago, there are talks that the markets have been hard-carry by the largest capitalized companies in the United States.

The worrying thing is whether this is healthy or not. I think over the years, Dimensional Fund Advisers have a few good research piece on this. (Read my comprehensive introduction to Dimensional Fund Advisers here)

The largest holdings of the MSCI World index is currently Apple, Microsoft, Amazon, Facebook and Alphabet. Together they make up 13.5% of the index. This is not too concentrated.

However, if we peep at the S&P 500, these 5 make up 22% of the index.

These index are market capitalization weighted, which means as certain companies get stronger, their share price perform better, they get bigger, their returns drive the returns more.

Some companies stay on top for a long time:

1. AT&T was the largest two for six straight decades beginning in 1930
2. General Motors and General Electric was in the top 10 at the start of multiple decades
3. IBM and Exxon was the main stays for some time

Here is a clearer view:

Prior to the 1980s, the larger companies were more dominant than today.

There is always another story to tell: There were a lot of dominant companies in the past. They dominate for decades. And now they are gone.

I am not saying that Apple, Microsoft, Amazon, Facebook, and Alphabet will falter. They have strong moats. They could stay for 3 decades and your investments in them would do well.

However, the lesson here is that its not that unsurprising for them to falter.

How Poor Would Your Performance bet if You Missed out on the Top Performers?

The FAANG stocks are represented by Facebook, Amazon, Apple, Netflix and Google. For the past decades, if you have invested in them you would have done really well.

But how would the US broad market do without these FAANG Stocks?

Surprisingly, if you exclude the FAANG stocks, the performance over the past decade have been rather respectible.

But the top performers are important if you missed out on them.

Dimensional did a study of global stock market performance from 1994 to 2018. They want to see the performance if you missed out on the top 10% performers for each year and if you missed out on the top 25% performers for each year.

1. If you buy a widely diversified basket of global stocks and hold them from 1994 to 2018, you will earn 7.2% a year
2. If you missed out on the top 10% performers each year, your returns drop from 7.2% to 2.9% a year
3. But if you missed out on the top 25% of performers each year, your returns drop to an atrocious -5.1%

Research from Eugene Fama and Kenneth French in 2006 provides evidence that these market premiums were driven in large part by a subset of stocks migrating across the market.

• Research shows that there is no reliable way to predict the top-performing stocks
• If we look at the top 10% performers each year since 1994, on average less than 20% of these top performers were ranked in the top 10% in the following year <– this means that top performers keep shifting

If You Want to Outperform do You Concentrate or Diversify?

My answer would be to concnetrate. But it seems the data show otherwise.

Dimensional did a study on the impact of diversification on the probability of outperforming the market benchmark. In this case, they are using the MSCI All Country World Index (which you can invest with the VWRA listed on the London Stock Exchange).

They are not doing with active funds but suppose you want to be like Buffett or some value manager and want to look in the large cap stock space and focus on stocks that have lower market capitalization, lower relative price and higher profitability.

They want to see what is the probability of outperforming if you concentrate on different levels.

The table shows that your chances of doing better is higher if you are more diversified. This seem to mesh with what Joel Greenblatt talked about. Joel stated that there are people who would use the screen he recommend and pick certain stocks from the screen that they have a higher affinity towards.

His observation is that they tend to do more poorly then if they just buy the whole basket.

These seem consistent with that theory.

To continue with that research, Dimensional’s strategy in this research would beat the MSCI All Country World Index likely due to the value premium and the high profitability premium.

In this chart above, it showed that if you remain very concentrated, you might not generate excess return above the MSCI ACWI.

Together with the “missing out on the top 25% performers of the year” research, the subtle conclusion is that for these kind of factor strategy, you better act dumb and buy all.

Your Performance If You Continue to Hold the Largest US Stocks

We started this article buy questioning if the performance is driven by the largest stocks in the index. And it seems the conclusion there is that this is not all that special.

When they examined the ability for the 10 largest US stocks to generate excess returns after they became the largest, they realize that as you held them longer, the performance have been poorer.

I think this coincide with why people think the “Dogs of the Dow” is a good strategy. The larger stocks tend to be more expensive and if you buy them, you are paying more for lower expected returns.

At this time, it might seem very befuddling, but that is the data since 1926 (and that includes that 1920s when the value premium also didn’t show up)

Conclusion

We started this article wondering if this tech domination is all that unique and from the past history, it is not uncommon to find the index dominated by large stocks. What is unique about this time is that the top stocks are tech-driven.

If I wish to be very clear, Apple is a consumer company, Facebook and Google are advertising companies and Amazon is a retailer. If we view things through that lens, I think it is pretty OK.

Eventually, tech is just an enabler.

In the 1980s, the tech back then was electronics and in the 1880s, there were a lot of new tech such as the formation of the telephone company AT&T in 1885.

There is a fear that if you missed out on the FAANG stocks, it will affect your performance. The research shows that it is not missing out on the FAANG stocks that we should fear but missing out on the top 25% performers of the year.

We often spit at diversifcation because it is a sign of a lack of conviction in your investments. For the financial planners, it is a way to sell to your clients who have blow up some investments far too many times.

But for a lot of us, diversification is also about capturing the returns of the top performers.

It is true that if you diversify, the poor performers will pull you down. But a poor stock can at most go down to 0%. A good stock can go above 100%. If you own 10 stocks and 8 of them end up as duds but 2 of them became 10,000% winners, then that portfolio will do well.

But if you only have 10 stocks, that might not be enough to capture that 10,000% winner because that 10,000% stock is so rare that you got to own more than 10 stocks.

For those who wish to grow their wealth at a very fast pace, they always encourage concentration. This is true. But you are still speculating that your 2 or 5 or 10 stocks will work out very well, much better than the index returns.

If your 2, 5, 10 stocks are duds, your capital may get impaired, you incur opportunity costs when measured against the market returns. It works if you have the edge, but if you do not have…. good luck to you.

I invested in a diversified portfolio of exchange-traded funds (ETF) and stocks listed in the US, Hong Kong and London.

My preferred broker to trade and custodize my investments is Interactive Brokers. Interactive Brokers allow you to trade in the US, UK, Europe, Singapore, Hong Kong and many other markets. Options as well. There are no minimum monthly charges, very low forex fees for currency exchange, very low commissions for various markets.

To find out more visit Interactive Brokers today.

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