This Is What Happens When You Own Only A Handful Of Stocks

It's good to have conviction. I have strong beliefs about things such as nutrition & fitness, environmental causes, and even what constitutes good tv worth sitting on the couch for.

However, strong convictions regarding individual stocks in your portfolio can be dangerous. It's great that you think Home Depot is a fantastic store, but it's not a valid reason to load up on it in your investment portfolio.

Here's why.

First, most stocks don't earn squat. From 1983-2006, the worst performing stocks (~ 6000) represented 75% of the entire U.S. investable universe. These stocks earned collective a total return of 0%.

Meanwhile, the best performers (~ 2000) representing the other 25%, accounted for 100% of the gains*. That's kind of a big deal.

You're not smart enough to know if your stock will be part of the 75% losing group or the 25% winning group. Don't feel bad, No One Is. This is why loading up on Home Depot just because you like it doesn't mean it's a wise move.

Second, research suggests that as you reduce the number of stocks in your portfolio your expected return is also reduced**. In a hypothetical test, 98 portfolios were constructed, each containing 15 randomly selected stocks from the S&P 500. 75% of the tested portfolios holding only 15 stocks failed keep pace with the market. Conclusion: only a small spattering of stocks accounted for the bulk of returns.

I ran a test of my own. I looked at actual investor returns using two common exchange traded funds; the S&P 500 and the S&P 100. I was able to get 16 years worth of data, which is farthest back communal history allows. Both ETFs are designed to represent the U.S. large cap market. But, one ETF has far fewer stocks. Obviously.

From the earliest common inception point (3/1/2000) through last week (3/1/2016), the S&P 500 index ETF (blue line, ticker symbol: SPY) produced far greater returns than the S&P 100 index ETF (green line, ticker symbol: OEF).

The S&P 500 (containing 5x the stocks of the S&P 100) returned 92.5% while it's little brother only managed 62.2%. That's average annual outperformance of 1.78% on the more diversified ETF.

See the pattern?

The more you reduce the number of stocks you own, the higher the likelihood you'll underperform the market. It's not enough to kick back and feel good because you own 25 mutual funds (this probably is not good by the way). Not only could those 25 funds only hold a small number of stocks, but they could own many of the same stocks.

Imagine what could happen if you found out you were holding the same stock in 6 different funds? If that stock is part of the 75% (probable), a bloated portion of your portfolio isn't likely to produce the return you're seeking, i.e., your total return also suffers.

Owning a lot of "stuff" doesn't mean you're diversified. It's important you know how much of the broad market you're capturing. If collectively your portfolio only owns a few hundred stocks, you're depriving yourself the full opportunity to capture gains from that elusive 25%.

If you want help understanding what you own, please reach out using the Shoot Us An Email contact form below. I'd be happy to evaluate your holdings to determine 1. the number of stocks you own, and 2. how much duplication (overlap) exists between the various funds in your portfolio. Once we identify a lack of market ownership or individual stock duplication, it's not terribly difficult to correct these imbalances.

* Honestly, I forget where I read this. Someone call me out on it so I can give credit where credit is due. It was such a powerful stat it's stuck in my mind for a long time; and I felt compelled to include it.

** The 15 Stock Diversification Myth, Bernstein, 2000.

#evidencebasedinvesting #stocks