- Apple is the most widely held stock among retail investors.
- Rough estimates place 1 in 5 individual investors owning Apple and those who do typically have a little shy of 20 percent of their portfolio in the stock.
- The dramatic outperformance of companies like Apple and Amazon often catches investors (and fund managers) by surprise, so they make suboptimal moves.
- Letting winners ride may somewhat concentrate risk, but selling winners too soon and keeping losers create a bigger problem known as the disposition effect - inadvertently tilting your portfolio towards losers.
- Understanding statistics and investor psychology is the key to beating the market. Investors may want to consider letting winners run further before selling.
If you bought Apple (NASDAQ:AAPL) 10 years ago, congratulations! You're up over 14 times your original investment. As Apple is the most widely held stock in America, there are a lot of people in this position. But, if you're one of the lucky ones, you probably noticed something peculiar going on in your portfolio. The value of Apple shares has steadily risen to the point where many investors have 30, 40, or even 50+ percent of their portfolios in Apple. In fact, if you put 10 percent of your portfolio in AAPL 10 years ago and 90 percent in the S&P 500, today your portfolio would be roughly 38 percent AAPL. If you did the same thing with Amazon (AMZN), you would have 54 percent of your portfolio in it.
Too much concentration of risk in one stock is a problem. But academic research shows a strong momentum effect-winning stocks tend to keep rising. My personal theory is investors' preference for cashing in on winning positions actually creates the momentum effect, as uninformed investors sell stocks when they should be buying based on the fundamentals, simply because the stocks are going up. I believe that one of the main reasons why investors underperform is that they fail to understand just how skewed equity returns are towards winning stocks, so they inadvertently sell winners and plow money into losers. Understanding the psychology around this can help you achieve superior investment returns.
Why you should typically let your winners run.
Research shows that the best performing 25 percent of stocks account for nearly all the market gains over time, and the top 14 percent of stocks return over 20 percent annualized. Meanwhile, a decent percentage of stocks simply fail. Investors who go out and pick 5-10 stocks for their portfolio typically fail to realize how skewed market returns truly are. What inevitably happens after a couple of years is their best 1-2 picks start to take over the portfolio. Investors have been shown to demonstrate a strong tendency towards loss aversion when picking stocks to sell. That means winning stocks are disproportionately targeted within investor portfolios when they decide to sell. Academics refer to this as the disposition effect.
Retail and institutional investors are equally guilty of doing this. (Here's a cool Harvard Business School study about this.)
I believe that the disposition effect and the momentum effect are inextricably linked and that the link is the main reason both mutual fund managers and retail investors underperform. When you look at mutual funds that undergo management change like the Harvard study did, the first thing new managers typically do is sell all the previous (fired) manager's losing stocks. Investors and fund managers tilt their portfolios towards low-quality stocks without even realizing it.
Don't punish winning stocks by selling out when they double, or triple, or even quadruple. Investors consistently underestimate how far high-quality stocks can rise. As long as your original investment thesis is intact, hold on to your winning stocks as if your life depends on it!
It's inevitable that your portfolio value will become concentrated towards your winners over time. The skew of individual stock returns ensures this. Trying to sell out of winners in your portfolio and buy into your other holdings will cause you to underperform. Therefore, if you have one or more stocks in your portfolio that are on fire, rising month after month, you want to let them run as long as your original thesis is intact.
Stocks don't necessarily follow a perfect bell-curve distribution, instead, there are fatter than average tails towards both amazing success and failure/bankruptcy. You need winners to balance out the losers, which are the mode (most common data point shown) in the statistical distribution.
Selling winning stocks just because they're going up is not a winning strategy. The best strategy is to accept that portfolio concentration is inevitable and enjoy having big winners. If a stock insists on doubling over and over again, I wouldn't deliberately reduce my allocation to it unless I felt it had become significantly overvalued. That said, although winners tend to keep winning, you don't want your entire portfolio in one stock. In my opinion, letting a position grow to over 40 percent is likely too much concentration in one position. The key thing to know however is that it grew to that number, so we aren't necessarily risking flushing our principal down the drain. If this sounds like a somewhat unscientific number, it's because it is. Investors selling too much too early causes the observed momentum effect in stocks in my opinion, so benefiting from the momentum effect trumps the benefit of diversifying away from winners too early in my decision-making process. Also, while riskier than an "academically" diversified portfolio, having 25-30 percent of your portfolio in AAPL due to the amazing rally over the last 10 years is nothing compared to the risk of having all your capital tied up in a small business, like a family restaurant or store.
One painless way to diversify away from winning positions is to reinvest the dividends from the winners in new ideas. At some point, however, you need to start diversifying and sell, even if it is beneficial to have a higher tolerance for stocks taking over your portfolio than your peers. If your portfolio is over 40 percent Apple or Amazon because you've owned it for long enough, make the easy call and get yourself to the nearest Mercedes dealership.
When cashing out, sell proportionally to combat the disposition effect.
The other takeaway you should get from this is that our natural tendency is towards loss aversion. While asset allocation works great on an asset class level, in an equity portfolio it's a good way to have a portfolio full of losers. I'll use an example to show what not to do.
Let's say that in 2008 you inherited $100,000 each in AAPL and GE (GE). 5 years later, you have approximately $268,700 in AAPL and $56,600 in GE. Don't focus too much on the individual companies, only on the concept. Can you see how if you put 1000 people in this position who need $100,000 for a down payment on a house, that the tendency would be to cash in the Apple and leave the GE alone to "diversify"? There are hundreds of studies on loss aversion as it relates to economics, but in this case, consider your options.
1. Sell the winner.
The most popular option is going to be to sell the winner to raise cash. However, by consistently selling winners, portfolio managers slowly poison their portfolios with junk companies and pare back their positions of winning stocks. This causes major underperformance.
2. Sell proportionally.
This is actually what passive ETFs do to combat the disposition effect. To sell proportionally, all you have to do is find the weight each holding has in your portfolio and take a little from each stock according to your weighting. By doing this, you ensure that pulling money out does not affect your asset allocation, only your investment decisions do. (Note that the AAPL weighting in this portfolio is exaggerated by there only being two securities in the portfolio. I did a 2 stock portfolio only to simplify things). If you need to take $100,000 out of your account, you can do so and have the same percentages in each stock that you had before. More institutional investors need to make this a rule and enforce it, by the way. It would eliminate a major cause of underperformance.
3. Sell the loser.
In our model portfolio you likely would be concentrating too much risk in one holding (100 percent!), but selling losers and taking the capital loss for tax purposes is the most +EV move you can make here. I would typically recommend option number 2, as I believe there is something to be said for your asset allocation being driven by your investment decisions and not your personal ones.
In case you were wondering, both investments ended up holding their own from 2013-2017, at which point AAPL took off and GE tanked. Today, if you chose option 3, you'd be closing in on having a million dollars worth of AAPL and not a penny invested in the GE dumpster fire.
Investing in a company with the returns of Apple or Amazon is an amazing experience, but strong performers tend to take over your portfolio. This is inevitable. Academic research shows that tolerating a somewhat higher concentration caused by prior outperformance leads to better returns via the momentum effect. That said, you don't want half your portfolio in one stock. By understanding statistics and psychology, you can benefit from the biases of other investors, let winners ride longer and avoid filling up your portfolio with losers.
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