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.