Monday, November 24, 2014

The Point of Diversification

The most common explanation of the value of diversification is avoiding big losses. Investing everything you owned in Nortel stock before the bankruptcy would have been a disaster. However, there is another side to the value of diversification.

Josh Brown reported that many are blaming active fund managers’ failure to keep up with markets in 2014 on Apple’s success. Apparently, many fund managers owned proportionally less Apple stock than its percentage in the index.

This failure to own high-flying shares is the other side of the benefits of diversification. In any given year, there are relatively few stocks that give huge gains. If you only own a few stocks and choose them essentially randomly, there is a good chance you’ll miss all the big winners. The advantage of an index is that it always gets it share of all stocks, including winners and losers. Keep in mind that a “winner” is a stock that performs better than the index, and a “loser” earns less than the index.

There is an asymmetry that makes winners rarer than losers. Some winners more than double, particularly if you look at periods of longer than 1 year. But losers can only lose 100%. The net effect is there have to be fewer big winners than big losers. And among random concentrated portfolios, there will be some portfolios that win big because they happen to pick a stock that wins big. But there will be more random portfolios that lose to the index because they miss the big winning stocks. To maintain balance, the rarer winning portfolios tend to beat the index by more than the more common losing portfolios lose to the index.

With this understanding, we see that fund managers moaning about missing out on big winning stocks is actually an expected result. With Apple having such a large market capitalization, the effect may be bigger this year than most, but it’s not all that unexpected.

All that said, the other theme of Brown’s article, that Vanguard funds had a big year compared to other funds, is mainly due to the fact that Vanguard’s fees and trading expenses are much lower than those of other funds. But the fact that Vanguard’s index funds didn’t miss out on Apple stock helped as well.

7 comments:

  1. Nice to see that there is "Monday Morning Quarterbacks" in the investment industry as well. Yes, you didn't buy enough of the stock that made the most this year, did you buy a lot of a stock that tanked? If they have a problem with their crystal balls, then maybe they should stick with reading tea leaves.

    The nice thing about looking back on things, is you can't predict what happened a year ago incorrectly (think about it).

    ReplyDelete
    Replies
    1. @Alan: I liked how it was somehow Apple's fault for performing well rather money managers' fault for not picking Apple.

      Delete
  2. Hmm, I could use my practice account to compare ETFs instead of teasing myself with comparing different stocks (that I will never buy). Nice.

    I'm still a bit unsure about the RY (N. Gambit) thing but I'm with iTrade and they have a US account friendly structure instead. Interesting.

    Thanks for this.

    ReplyDelete
  3. Michael, I too was burned during the Nortel crash. But not because I owned Nortel directly, but because it made up such a huge % of the TSX. I'm glad there are now capped TSX indexes to follow. I'd be willing to give up some upside (Apple) to prevent a big downside (Nortel). Albeit, the US market is much larger, and a Apple crash wouldn't cause as much damage as a Nortel did.

    But I still won't buy from an actively managed MF :)

    ReplyDelete
    Replies
    1. @Paul: Fortunately for long-term index investors, if one stock makes up a large percentage of the index, they have benefited from the rise. It's still painful to see gains erased, but it's better than having bought in after the rise. I've been fully invested for some time now and so I'm not too worried about stocks like Nortel because I'll have to be part of the rise to experience a fall.

      Delete
    2. Which speaks to having a diversified portfolio, with age appropriate % in the indexes, bonds and cash. If the Nortel crash happened when you were nearing retirement, it could have been pretty ugly.

      Delete
    3. @Paul: Actually, I have nothing in bonds and very little in cash. But I don't recommend this for others; my employment situation is very different from that of most people. It's true that the Nortel crash would have been painful for someone nearing retirement, but if that person had owned XIC throughout Nortel's run-up, his or her portfolio would have grown by less. How we see this sort of situation depends greatly on the start and end points we focus on.

      Delete