An old investing adage says, “To get rich, invest it all in the one right stock. To get poor, invest it all in the wrong stock.” We’ve seen this recently. The great importance of diversification for planning successful strategies for essential goals, where failure is not an option, cannot be overstated.
Diversification is a choice which, unlike timing for market volatility, is both important and under your control. However, too many investors hold large, concentrated positions in a single stock or two, or maybe focus on holding a collection “for the long-term.” This may be due to employee incentives, inheritance, or chance stock bias from keeping your “winners” and, over time, selling off the “losers.”
Over familiarity with big tech companies like Apple or highly appreciated tax positions discourages many investors from broadly diversifying their portfolios. All too often, this leads to a common but sad cautionary tale: tragic declines in wealth from large over weights in single securities. Classic Rochester examples are Eastman Kodak and Xerox.
Detailed studies of empirical stock data indicate that underperformance — or even going under — regardless of past good performance is much more common than investors realize. Dramatic declines during 2022 show us how millions were playing with financial fire with popular stock bets.
Shifting Financial Landscapes
Formation and innovation of companies are signs of a healthy industry and economy. Financial markets reflect this dynamic as share prices track their value from the birth to the death of publicly listed companies.
Exhibit 1 shows there is substantial turnover in publicly listed stocks. A little over one in five U.S. stocks listed in the markets at any given time, on average, will delist within five years based on survivorship statistics. Survival rates for stocks continue to decline over longer periods, with just under half of stocks still trading 20 years later.
Delistings are not necessarily bad. Delisting may be a positive investor experience due to a merger. Delisting events may be categorized as “good” or “bad” based on a stock’s particular delisting circumstances. For example, in a “good” delist such as a merger, shareholders would be compensated after the acquisition, sometimes very well. On the other hand, an unwanted delisting due to deteriorating financial condition would be a “bad” delist, adversely impacting investor wealth. Over 20 year periods, an average of 18% of stocks went the bad-delist route.
The goal of investors is to prosper, not just survive. But Exhibit 1 shows only 21% of stocks achieve that. A little over a third of stocks, on average, both survived and outperformed the broad U.S. market for even only five years — a lifetime for traders; this rate continues to dwindle over 20 years to a little more than one in five.
Average survivorship and outperformance rates for cross-sections of US stocks
Over rolling periods formed each month, January 1927–December 2020
Past performance is not a guarantee of future results. Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. There is no assurance buy and hold strategies will be successful. Source: Dimensional Fund Advisors research from CRSP, University of Chicago and Compustat.
The range of potential outcomes, good and bad, that any single stock may have is enormous — even among those surviving long periods. Past performance is no assurance of future positive returns.
Exhibit 2 shows distributions of returns in excess of the broad U.S. stock market return for stocks that survived over rolling periods of five, 10, and 20 years. It is formed using the cumulative average return in excess of the market at each percentile. The median individual stock underperforms the market across all three horizons. Not until we reach the 57th, 57th, and 56th percentiles at the 5-, 10-, and 20-year horizons, respectively, do we see positive excess returns relative to the market. Although the percentage of underperformers is similar across time horizons, the magnitudes of excess returns at the extremes are smaller at longer horizons until those very few reaching the extreme tails. The odds of winning big are almost entirely offset by the odds of losing big.
Average return in excess of the US market by percentile for the cross-section of surviving stocks
Over rolling periods, January 1927–December 2020
Past performance is not a guarantee of future results. Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. There is no guarantee strategies will be successful. Source: Dimensional Fund Advisors research from CRSP, University of Chicago and Compustat.
Diversification is More Rewarding
For investors owning a stock with a strong performance experience during their ownership, diversification might seem like “worsification.” That is, expected returns could be less relative to their successful concentrated bet to date. Typically, such investors justify their confidence with a story that it represents “a successful company.” The company, they believe, will continue to prosper just as it did in the past. Therefore, the possibility of a bad future outcome does not occur to them. Their unstated belief is that the world as they have experienced it will not change due to technology, social trends or politics.
Take, for example, stocks that have outperformed the market over the previous 20 years. Exhibit 3 shows that, on average, about 30% of these stocks will continue to survive and outperform over the following 10 years. On the other hand, of the stocks that have underperformed over the previous 20 years, the average subsequent outperformance rate is also 30%. In other words, winners are no more likely than losers to beat the market going forward. This shows why making decisions solely on long-term past performance is not useful for informed investment management.
Outperformers do experience a lower bad delist frequency than underperformers, however, which likely reflects the impact of performance relative to firm size. For example, looking at the same data set of U.S. stocks, the median market cap of past winners was $4.2 billion as of December 2020 — compared to $800 million for past losers. However, the bad delist rate is still 3.0% even for past outperformers; the bankruptcies of companies like Enron, Chesapeake Energy, and Circuit City remain painful memories for investors and former employees who faithfully held on to a bitter end.
Unconditional and conditional performance of individual stocks
Using 10-year rolling periods, January 1947 – December 2020
Past performance is not a guarantee of future results. Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. There is no guarantee strategies will be successful. Source: Dimensional Fund Advisors from CRSP, University of Chicago and Compustat.
An informed portfolio diversification strategy helps you capture market returns more reliably, limit idiosyncratic risk of individual stocks, and more effectively tilt toward market segments with higher expected returns — including stocks that may not have performed well for many years, but still having high expected returns. Even allowing for capital gains taxes, transitioning from a concentrated portfolio to a broadly diversified approach can deliver more reliable wealth outcomes for those with a sensible horizon for planning their retirement income and legacies.
The long-term benefits of diversification can outweigh the short-term costs associated with liquidating outsize positions. A CFP® wealth professional can help you plan and implement integrated tax-sensitive strategies that allow for your goals and preferences, that simplify and empower your life, and that give you confidence even during troubled markets and uncertain times.