Monday, March 27, 2017

Stock picking vs. diversification

I've seen a lot of recent references to this great paper (pdf) from Hendrick Bessembinder at Arizona State.  The paper notes that all of the net gains from equity ownership over time come from a very small sliver of the market.  Most firms underperform over time.

Here is a graph from the paper.

There are two contrary conclusions we can reach from this.  From the paper:
These results reaffirm the importance of portfolio diversification, particularly for those investors who view performance in terms of the mean and variance of portfolio returns...The results here show that underperformance can be anticipated more often than not for active managers with poorly diversified portfolios, even in the absence of costs, fees, or perverse skill.
At the same time, a preference for positive skewness in portfolio returns is not necessarily irrational, and it is known that diversification tends to eliminate skewness from portfolio returns. The results reported here also highlight the fact that poorly diversified portfolios occasionally deliver very large returns. As such, the results can justify a decision to not diversify by those investors who particularly value positive skewness in the distribution of possible investment returns, even in light of the knowledge that the undiversified portfolio will more likely underperform.  
The lesson for diversification is clear.  But, it seems like there is an additional factor here having to do with rebalancing.  For the fully diversified investor, rebalancing would be important - even a source of profit.  But, for the less diversified investor, the positive skew would favor momentum.

I wonder, for the non-diversified investor if the idea that there is a tradeoff between positive skew and average underperformance is necessarily true.  It would depend on the balance between winners and losers.  If an investor took a sort of barbell approach, only investing in equities with highly variable potential outcomes, it seems that there could be a large advantage created by that skew for portfolios that maintained positions without rebalancing.  It would come down to skill, in the end.  Small differences in the ability to pick winners - say, picking 60% winners instead of 40% - would make a huge difference in returns.

This seems like another piece of evidence that the real losers are the sort of reputation-based, semi-active portfolios that basically follow the indexes, with minor adjustments, or a sort of middle-of-the-road safe basket of tactical portfolio adjustments that are fairly conventional.  These are the sorts of portfolios over time that tend to have net losses after costs.  But, both fully passive and highly selective portfolios can do well.  Fully passive is certainly recommended for most investors, but highly selective seems to be a reasonable choice, if the risks are known, with tremendous potential upside, and I suspect the benefits of that kind of portfolio tend to be underappreciated because it gets lumped in with "active" portfolios, which sophisticated observers who appreciate EMH are supposed to understand are a loser's bet.


  1. I'm wimpy and lazy. Sticking with a Wilshire 5000 Index, bond index and foreign stock index. I'm the Vanguard prototype.

    1. And smart! That's clearly the prudent course.

  2. I echo bill's sentiments.

    I had a great idea when oil was at $125 a barrel and oil tankers were full and berthed in Malta, nowhere to offload. Short oil!

    The market went to $147 and I got murdered. Sure, the market was manipulated, but as an investor you have to play the reality, not the theory.

    I am happy to say, buying land in L.A. has been a (perhaps lucky) turkey shoot, though I am out of that game now.

    The big lesson: Make sure you are on the side of the manipulators!

  3. Great article - captures much of the paradox that swirls around investment approaches. There's also some equilibrium factors I think - if everyone is indexing then active may become more profitable, or when active is greater then passive avoids overpaying and captures some upside - passive aggressive you might say!
    Either way I wonder sometimes if folks actually are active because in a 2% inflation + 2% interest rates world then 5-10% in the stock market is quite good - but in a 4+4 world it's perhaps not so good if you see what I mean.
    Are we still in a 2+2 world? I need to know.

    1. Seems like we're in a 2+2 world, at best, doesn't it?

      In some ways, I think we can think of returns to passive investing as a sort of positive externality of active investing (in the broadest sense, including, VC, new firms, etc.). It could be that gains to active investors are generally small, on net, because in liquid markets they are largely captured as consumer surplus and as gains by passive investors.

      In an extreme thought experiment, imagine that you are the only active investor. Apple sells for $150, and you decide it's worth $200. But, all others are passive, so there is no seller to buy shares from. In the extreme, you might buy one share for $200, but the passive population simply holds their shares as the price reflects the new allocation. Or, maybe, seeing your limit order at $200, the passive market shifts its sell order up to $200 and you never buy a share. The passive market internalizes the gain.

      The transfers and externalities between active and passive investors are a fascinating topic to me. Does anyone know of any papers that have been done on this idea?

  4. I'm not aware of too much "hard" academic study, but there is some interesting work here: if you don't already know it.

    PS - I'm curious what you mean in this context by "consumer surplus"?

    1. He has some great stuff, doesn't he? (Looong posts, though.)

      Here, I just mean, in the broadest sense, active investment leads to innovations that improve our lives. The early VCs in Google earned huge returns. Passive investors have captured some of those returns as Google became part of the broad market basket of diversified assets. But, mostly, the value of that investment has gone to consumers.