Diversification: It Really Doesn't Matter

The idea of a diversified holding of stocks is often said to save many investors from losing large amounts of money. However, the concept of diversification often is misunderstood in its most basic context. Diversification only matters when an investor is spread among completely different asset classes such as real estate (real property and not in the form of primary residence), business ownership, gold and silver (bullion), and stocks. All other notions of diversification are often just that…notions.

For do-it-yourself investors who wish to buy stocks, the mantra has been to diversify your risk. I guess this means the more stocks you hold the less you’ll lose. Along these lines, diversification is supposed to reduce downside movements while participating in upside action. The fewer stocks you have the more you’ll lose. The more stocks you have the less you’ll lose. Unfortunately, real life suggests that the more stocks a person holds the greater the risk of loss. How is this possible? I have my suspicions as to the reasons. However, I would like to provide the evidence for my claim that diversification isn’t all that its cracked up to be.

Many people who follow the stock market know that the Dow Jones Industrials Average is the most widely quoted index. However, most people “know” that the best index to follow for a broader understanding of how the entire stock market performed rely upon the Standard and Poor’s 500 (S&P 500) index. After all, the S&P 500 contains 500 diversified companies in many different industries. This is contrasted by the Dow Jones Industrials, which only contains 30 companies.

However, did you know that the top 43 companies in the S&P 500 comprise 50% of the movement of the index? The top 131 companies comprise 75% of the movement of the index. By the time you get to company number 258, you have reached 90% of the movement of the entire S&P 500 index. This means that the remaining 242 companies in the index only contribute 10% to the movement of the index. It’s as if those companies on the bottom half don’t even exist.

How is it possible that the S&P is so strongly influenced by the top 258 companies? The answer is that the S&P 500 is considered a market value weighted index. This means that,

“…movements in price of companies whose total market valuation (share price times the number of outstanding shares) is larger will have a greater effect on the index than companies whose market valuation is smaller.”

Basically, larger companies have more influence on the index. For this reason, most people who invest in an S&P 500 index fund or ETFs are really investing in companies that have the largest valuation rather than a “well diversified” portfolio.

It wouldn’t be enough to simply say that the S&P 500 index isn’t as diversified as most people think. We need better evidence to show that the concept of diversification can’t stand on its own. Using the Morningstar.com database of various domestic indices, I compared the 1-year, 3-year, and 5-year performances to see if there are any distinguishing characteristics. Because this has been a declining market of the last 2 years we should see the indices with fewer stocks with the greatest losses. If there were any gains then the least diversified index should have the highest percentage gains.

Unfortunately, the reality is quite sobering. When comparing Morningstar’s 37 domestic indices in the 1-year category:

• Ranked #1 was the healthcare index with a –20.55% loss with 178 companies
• Dow 30 was ranked #17 with a loss of -35.05%
• Russell 2000 (2000 companies) was ranked #20 with a loss of -35.27%
• S&P 500 was ranked #23 with a loss of -36.47%

In the 3-year comparison:

• Ranked #1 was the energy index with a 11.92% gain with 121 companies
• Dow 30 was ranked #8 with a loss of -9.3%
• S&P 500 was ranked #21 with a loss of -12.31%
• Russell 2000 was ranked #29 with a loss of -15.44%

In the 5-year comparison:

• Ranked #1 was the energy index with a 11.92% gain with 121 companies
• Dow 30 was ranked #14 with a loss of -2.66%
• S&P 500 was ranked #23 with a loss of -3.61%
• Russell 2000 was ranked #27 with a loss of –3.78%

It seems as if the more diversified the index, the worse it performed. The only time the Dow 30 came at the bottom of the list was when we compared the 1-week, YTD, 4-week and 13-week ranges. Remember, a truly diversified index is supposed to overperform other indices on the downside (go down less) and underperform on the upside (go up less). If you’re investing for the “long haul” then the data tells us that you shouldn’t be invested in the S&P 500 or any other index that is “truly diversified.”

Another way to test this assumption of diversification on your own is to eyeball the different periods of time using the interactive comparison chart at Yahoo!Finance.com. First, pick the S&P 500 or any other “diversified” index and compare it to the Dow Jones Industrial Average. Then select the timeframe that you’d like to compare (5 years or more is best). Once the timeframe has been selected you can slide the timeframe backwards to any period you want. You’ll see that the Dow frequently overperforms on the upside and overperforms on the downside from 1980 onward. Prior to 1980, The Dow and S&P go back and forth in either underperforming of overperforming. The point being, diversification really doesn’t matter when it comes to spreading your risk.

Sources:

• IndexArb. Index Component Weights of Stocks in the S&P 500.
  accessed online March 24, 2009.

• EDinformatics. Investor Education: S&P 500 Index. Accessed online March 24, 2009.

Comments

[Igneous]

A most interesting article. A bit of a negative though as with most financial articles it seems is the lack of ideas on alternate solutions....or a better way to "diversify".
How does the author invest his portfolio now?

2009 Mar 25 10:50 AM

[Patrick22]

Is it April 1st already? Is anyone allowed to post on this site? Look, I don't profess to be extremely knowledgeable on the topic of risk, but even I can tell you that there are different kinds. Diversification doesn't eliminate risk, it only lessens SINGLE ISSUE RISK or unsystemic risk. You cannot diversify out of the systemic risk of stocks by buying more.

Here is how diversification into the S&P 500 helps:

GM 1yr return -82%
S&P 500 1 yr return -40%

In your theory, I only hold 1 stock versus 500 (or 248) and yet I've not eliminated risk?

Or how about diversifying into TIP Bonds 50-50 (here you are diversifying SYSTEMIC risk of equities):

S&P 500 1 yr return -40%
S&P/TIP 50/50 1 yr return -22%

Come on, how about just a quick read through Investopedia? You might also want to add the term "Data Mining" to your research.

2009 Mar 25 11:10 AM

[riskmgr]

Toucalit, reading your article reminds me of a salient line from Tao Te Ching "Those who know don't talk. Those who talk don't know." Please, finish your undergrad work and read a couple investopedia entries, these types of lines of thinking are more suited towards an audience of high school students rather than seeking alpha readers.

2009 Mar 25 11:39 AM

[Dividend Inc]

Greetings riskmgr,

I guess you have a point...I, like Tao Te Ching (clearly no comparison of philisophical intellect), have something to say. I certainly won't rise to the level of Tao but I still have to call it as I see it.

After years of best of breed risk management tools have percolated to the top and has wiped out large amounts of the public's money we have to wonder if the models of risk management that is hyped to the public really benefits them.

After all, if the general public losses 30+ percent when it wasn't necessary then something is definitely wrong. I recently spoke to a portfolio manager who said they could not sell there positions because they had a fidicuary reponsibility to their client. Never mind the fact that their client was losing trust fund money.

It is this perverse unwillingness to examine the premise of the rules in place that allows for the condition that the American economy currently is in. Although, if taking pot shots is the best response then I guess it'll have to suffice.

Greetings Igneous,

I only hold 2-5 stocks at a time. This has resulted in a minimum of 15% total return annually since 2004. The average holding period is 9 months in a tax deferred account. My blog outlines my investment approach at the following link dividendinc.blogspot.c... I am very specific as to how I approach investing and the companies that I track.

Greetings Patrick,

Your point is well taken however single issue risk is not eliminated by having the performance of that single issue buried in a portforlio of 200 stocks. All that is reduced is the understanding that the single issue that is having problems needs to be sold off.

Thanks for taking the time to critique my work...as you said riskmgr, in not so many words, thank goodness I don't do this for a living.

2009 Mar 25 01:56 PM

[riskmgr]

The thing is, you don't really have to "call it as you see it". You can think it as you see it, but the call itself is not necessary. Without the tools needed to analyze stocks, forecast and interpret macroeconomic data, and continually monitor a stock investment, it is simply better to take a passive index approach and take the market return. The problem is, folks who are capable of doing that area already doing that. Short the index, long the single name. But single name stock ownership isn't for everyone, and it would be a disservice to suggest to novice investors that index fund investment is a poor idea by simply mining data in one of the worst economic periods in United States history. Returning to Lao's words - someone who has truly navigated the depths of the Great Recession to the tune of a 15% total return since 2004 doesn't need to say a single word. Investors would be knocking down the door in order to obtain that sort of sage advice! Mere mortals like me have been losing money.

2009 Mar 25 02:31 PM

[Dave Shafer]

The average person who doesn't want to or can't analyze single company stocks should not be in the market. There are many products out there with guarantees associated with them. The fact that most folks are investing in mutual funds inside their company's 401K is the problem. These folks would have done better if they put their money into an CD, annuity, or even a savings account over the last 20 years. It is the propaganda from the mutual fund companies combined with the blessing from the government that strongly encourages folks into buying mutual funds, which is probably the worse thing the average person can do. The author of the post has it right about the failure of diversification. Mutual fund diversification does keep losses from going to 100% at the cost of an opportunity to get double digit returns. But it matters not if that 50% loss causes folks to make additional market timing mistakes as it has proven to do.

2009 Mar 26 09:28 AM

[pacman1947]

You write some great articles, man! This one also shows the lunacy of the so-called "L Funds", or life funds, that mix and match stocks and bonds in various ratios depending on the target date.

The returns over 5, 10, 15, 20, 30, even 40 years with these mixtures reflects nothing more than a buy and hold strategy. In today's markets, that's a recipe for suicide. It worked before the markets were corrupted by hedge funds and day traders, and then overwhelmed by derivatives. The volatility means that as you approach the day you need the money, it can be destroyed by a crash (we've had three in the last 22 years of 50% or more). Throw in the management fees for babysitting the portfolio ratios, and the losses mount. Bonds have become nearly as volatile, as companies fold as fast as losers in a poker game. Wait a few years and you'll see what happens in this uber-recession that is underway.

So much for diversification in stocks and bonds.

Great thoughts, sir.

2009 Apr 02 07:21 PM