# "All the market return comes from just 4% of shares"



## Fella (8 Jun 2018)

_Copied from another thread _

There was lots of discussion on how many stocks you need to own , I remember Brendan (the site owner) suggesting 10 stocks is enough.
Sarenco popped up some stats that indicated holding 10 stocks is not enough . The point Sarenco made very well was that the bulk of stock market gains come from a tiny percentage of the stocks and if you miss one of these your likely to do no better than investing in bonds or just saving money in the bank.

I didn't just take Sarenco's word for it but researched it myself and as always he was in fact correct , that was enough for me to avoid individual stocks and go with the investment trust route.

_Stock markets have delivered big long-term returns because of the stupendous returns earned by a tiny minority of companies. Bessembinder calculated that the US market has earned $32 trillion (€30 trillion) for investors since 1926. Of the 25,782 stocks in his sample, some $16 trillion (€15.1 trillion) in wealth creation was generated by just 86 companies. The top 1,000 stocks accounted for all of the $32 trillion wealth creation.

Put another way, one third of one per cent of stocks accounted for half of the overall market gains; less than 4 per cent accounted for all of the market gains; the remaining 96 per cent collectively generated lifetime dollar gains that merely equalled the amount earned through treasury bills.
_


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## Brendan Burgess (12 Jun 2018)

When Sarenco made this point originally, I had meant to research it, but never got around to it.

It's very important.  My understanding was that from a portfolio of 10 blue chip stocks, you would pick something like 2 dogs which would fall by 100%, 6 shares which would give a reasonable return, and 2 stars which give a great return well outweighing the losses on the two dogs.

This research quoted by Fella seems to suggest that most shares generate nothing at all. And just 4% of shares generate a positive return.

If this is correct, then 66% of people who pick 10 shares would not pick one of the 4% stars.  If my 20% stars is correct, 90% of 10 stock portfolios would include at least one star.

So it would be clear that despite the costs and despite the tax complexities, one should buy a collective fund. Hopefully if they have a few hundred shares, they will pick a few of the stars which will make up the return.


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## Brendan Burgess (12 Jun 2018)

So, is Besseminder correct?

I presume that he is factually correct - 96% of all US stocks generated no return between 1926 and 2016. I am surprised by the figure, but does it tell us that much?  Most of these would have been judged from their Initial Public Offerings.  So if you picked 10 shares at complete random over the years, most would have done poorly.

It just does not seem consistent with the experience of those I know who have invested in shares.  Most seem to have made a lot of money through shares. But maybe I have some sort of bias and am excluding all the people who have lost money.

I know people who have lost money. One person told me that his diversified portfolio of shares had fallen by 90%.  I was shocked at this but when I investigated, his "diversified" portfolio was comprised of AIB, BoI, ILP, Anglo, CRH, Readymix, (the company which made radiators?) and UTV. This was, in my view, a three stock portfolio and not diversified.

What about my own experience? Over the years, I have had two shares which lost 80% - AIB and Power Securities (The capital disappeared almost completely but I did get a stream of dividends.) I have had a few which disappointed me. Sold at a loss or not much of a gain. But I have a "problem" now with capital gains. I have two loss makers. Aryzta which is down over 50% and an ISEQ ETF which is down about 20%. ( Oddly enough, Aryzta is a fallen star. It had risen to such an extent, that I reduced my holding as it accounted for over 10% of my portfolio. )

Was I just lucky? If so, maybe my luck will run out and my portfolio will generate no further return over the next 20 years.

I did not engage in any stock picking, so any outperformance would be luck instead of skill.

But I suspect it's because I was not picking from a universe of 25,782 shares. I have always advocated picking ten blue-chip shares.  So I probably had screened out most of the speculative shares which go bust eventually.


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## Brendan Burgess (12 Jun 2018)

I wonder if Bessbinder's statistics have been replicated in another mature stock market like Europe?

Does all the return come from just 4% of shares?

If one picked the top 100 shares by market cap in Europe 20 years ago, how would it look today?


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## Brendan Burgess (12 Jun 2018)

Now, here is the embarrassing bit. I attach the Chapter I wrote in May 2001.

In summary, I recommended picking 10 of the Top Irish Companies 




_The top Irish companies in Table 5 are well diversified in terms of industry sectors and overseas earnings.  Pick any ten of these shares which take your fancy. It's impossible to tell which will be the best performers over the coming years. 



Three of the stocks are financials and three of the stocks are in the food industry. Don't select more than two from any sector or you could by overexposed to that sector. 
_
(There seems to be an error here. 4 of the stocks were financials, not three. It says that three were in the food industry, although only two from that list. So I suspect that Waterford Foods might also have been in that list.)

In retrospect, I am very surprised at how many dogs were in that selection of 16.

It's hard to follow what happened  to some of them, but I think that the following lost most of their value:


Elan
BoI
AIB
Anglo
Independent 

Riverdeep 

Iona
That a 50% complete failure rate.


IAWS
rose dramatically, converted to Aryzta and has since fallen by 80%.  I don't know what the return has been since 2001.

I don't know how the following have done because of share splits, takeovers,etc.  Does anyone know?


Smurfits
Galen
Viridian 

CRH
The following have generated a good return:


Kerry Group
Ryanair
DCC

So, in retrospect, it's closer to

40% failure
40% OK
20% stars


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## Brendan Burgess (12 Jun 2018)

How would an investment in the Index have done?




If you had restricted 20% of your portfolio to financial services, your return since 2001 would have been 68% (80% of 110% return on ISEQ General =168%)


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## RedOnion (12 Jun 2018)

Brendan Burgess said:


> If you had restricted 20% of your portfolio to financial services, your return since 2001 would have been 88% (80% of 110% return on ISEQ General)


Doesn't sound like you're allowing for negative return in that calculation? Would it not be closer to 70%?


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## Brendan Burgess (12 Jun 2018)

Hi Red 
Oops. Corrected now. 

Thanks

Brendan


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## Duke of Marmalade (12 Jun 2018)

Brendan Burgess said:


> If this is correct, then 66% of people who pick 10 shares would not pick one of the 4% stars.  If my 20% stars is correct, 90% of 10 stock portfolios would include at least one star.


You had me struggling for a while there _Boss _but yes your math is correct.  Fascinating to read that list of shares from 2001.  I remember them well. And absolutely astounding that so many have tanked.  I thought the banks were a once in a lifetime freak but Elan, Riverdeep, Iona.  If ever there was a cautionary tale against a concentrated portfolio, this is it.


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## Brendan Burgess (12 Jun 2018)

Duke of Marmalade said:


> Fascinating to read that list of shares from 2001. I remember them well. And absolutely astounding that so many have tanked.



It was very surprising for me too.   I would love to get the data on all shares in Ireland which had a market cap in excess of €1 billion to see how they fared.

Here are today's top companies
CRH €27B
Ryanair: €18B
Kerry Group €16B
AIB  €13B
BoI €8B
Paddy Power: €8B
Smurfit Kappa: €8B
Kingspan: €7B
Glanbia: €5B
Tullow Oil: €4B
Cairn Homes €1.4B
Dalata : €1.2B
Irish Continental :€1 B
Aryzta €1B


Will 5 of these crash to zero?  Two or three probably will.  And, there could be another banking crisis which takes out AIB and BoI. 

Brendan


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## T McGibney (12 Jun 2018)

Duke of Marmalade said:


> You had me struggling for a while there _Boss _but yes your math is correct.  Fascinating to read that list of shares from 2001.  I remember them well. And absolutely astounding that so many have tanked.  I thought the banks were a once in a lifetime freak but Elan, Riverdeep, Iona.  If ever there was a cautionary tale against a concentrated portfolio, this is it.



Elan was always a high risk proposal given their fortunes were highly conditional on unpredictable clinical drug trials.
Riverdeep was a bottle of smoke even in 2001.
Iona was effectively an overgrown tech startup.



Brendan Burgess said:


> It was very surprising for me too.   I would love to get the data on all shares in Ireland which had a market cap in excess of €1 billion to see how they fared.
> 
> Here are today's top companies
> CRH €27B
> ...



My money would be on Paddy Power, Tullow Oil and Dalata.


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## Sarenco (12 Jun 2018)

Brendan Burgess said:


> So, is Besseminder correct?


While it certainly true that the bulk of stock market gains come from a small minority of stocks, I would be inclined to treat the Bessembinder paper with some caution.

Firstly, he is saying that the best-performing 4% of publicly traded companies when stated in terms of lifetime dollar wealth creation, explain the net gain for the entire US stock market since 1926, as other stocks collectively matched Treasury bills.  That's not the same thing as saying that "all market return comes from just 4% of stocks" and strikes me as a slightly odd way of measuring returns.  In contrast, Dimensional Fund Advisors found that from 1980 to 2008, the top-performing 25% of stocks were responsible for all the gains in the broad US Stock Market and the bottom 75% of stocks collectively generated annual losses of around 2% over that period.

Secondly, the statistics reference the broad US stock market (as measured by CRSP).  Currently roughly 80% of the stocks that constitute the total US stock market by number make up less than 10% of the market by capitalisation (i.e. there are a heck of a lot more small caps than large cap stocks).  If you compiled the statistics using only large caps (S&P500), you would get materially less dramatic results.

Again, I don't want to detract from the general point that the bulk of stock market gains come from a small minority of "super-performers" (think Apple, ExxonMobile, etc.) but I do think the Bessembinder paper exaggerates the position somewhat.

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2900447


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## joe sod (12 Jun 2018)

*"All the market return comes from just 4% of shares"*

Is this not a follow on from the fact that very few companies that existed in 1926 are still in existence today. Therefore is all the wealth generated since that time unfairly attributed to the "survivors". For example only two companies Microsoft and Cisco are still in existence today from the dot com era (or are still dow 100 companies). Therefore is all the wealth generated in the tech boom unfairly attributed to them now because they survived. In other words if you were lucky to have  only invested in Microsoft and Cisco back in 2000 you would not have earned the big wealth earned since the dot com bust.


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## Brendan Burgess (12 Jun 2018)

Are you sure about the 2 out of 100 figure? 

I don't think that the other 98 companies disappeared.  They probably merged and changed their names. 

Brendan


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## Colm Fagan (12 Jun 2018)

On the other hand, the attached link shows how well a so-called "sloth fund" has performed.  The fund has kept the same stocks (and their successors) since 1935 and has an excellent performance.  

https://www.linkedin.com/pulse/revisiting-80-years-sloth-kevin-mcdevitt-cfa/


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## Brendan Burgess (13 Jun 2018)

Hi Colm

That is a fascinating article. 

How have these original 30 companies fared? Quite well overall. Only four have gone bankrupt, with Eastman Kodak the latest example in January 2012, although, as mentioned above, the position was sold in 2011's third quarter after the share price fell below $1. Eighteen of those stocks still remain in the portfolio in some form. But many of these have morphed through mergers and acquisitions. Only five companies remain in their original incarnation:  [broken link removed] [broken link removed],  [broken link removed] [broken link removed],  [broken link removed] [broken link removed],  [broken link removed] [broken link removed], and  [broken link removed] [broken link removed].

13% bankruptcies in 80 years is very low. In my sample there were 40% falling close to zero in 17 years.

And it's quite possible that the likes of Eastman Kodak produced a positive return on investment over the 70 years it was in the portfolio.

Brendan


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## noproblem (13 Jun 2018)

Just wondering if investing in some of the different managed funds would give much the same %'age results?


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## Brendan Burgess (14 Jun 2018)

A good article on the issue here 

*The Math Behind Futility*
An overlooked statistical concept shows why it’s so hard to beat a benchmark.

It suggests that the under-performance by active managers is due to the positive skewness in the market. 

I don't fully understand it.  I would have thought that the if a few fund managers picked a higher than average proportion of the stars, their performance should be stellar.  But I don't think that there are many stellar performers.

Don't most actively managed funds have around 100 stocks in them anyway? If so, they should pick a few of these star performers. 

Positive skewness is a risk for someone who picks only 10 shares. They might miss out on the stars completely.

Brendan


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## Duke of Marmalade (14 Jun 2018)

Yes interesting stuff.  The article states that the average growth of the S&P was 1.5% higher than the median growth.  That is one mathematical definition of skewness. We are most familiar with it in the distributon of incomes.  The average income is considerably higher than the median as the Donald Trumps easily outweigh the down and outs.

The premise of the article is that stock picking and indeed active management is purely a game of chance, and I am not going to quibble with that.  So ignoring charges the active management population as a collective should match the benchmark.  But that means the average is the same as the benchmark and so too is the median.  The problem is that in comparing active management with passive management we mix the calibration.  When we say the S&P grew 10% we are talking about an average.  When we say the average active manager underperformed the S&P we are talking about the median.


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## Brendan Burgess (14 Jun 2018)

I get it now. If 10 managers have the following performance
9 managers score a 4.
1 manager scores a 10
The average performance will be 4.6 so 90% of them will be worse than average.

But that is a side issue.  The main point for investors is whether 10 shares is enough. 

Brendan


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## Duke of Marmalade (14 Jun 2018)

Yep


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## Gordon Gekko (14 Jun 2018)

Is the issue here that people are looking at it the wrong way? It’s not about identifying the winners per se, which is bloody tough. It’s about avoiding the losers which, although still difficult, is easier than identifying the winners. The more that I read up on this, the more my own view strengthens; basically, it’s mad to own less than (say) 30 shares.


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## Brendan Burgess (14 Jun 2018)

Hi Gordon 

But the stars give most of the gain, so you have to have one or two of them in your selection. 

You can lose only 100% on a dog, but the stars are unlimited. 

I thought that 10 blue chips were enough - based on experience.  I would like to see the data for other markets.

Brendan


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## Duke of Marmalade (14 Jun 2018)

Positive skewness is when a few stars pull the average of the index up above its median.  In positive skewness the fewer stocks you hold the more likely that you will underperform the index by missing the stars.
Negative skewness is when a few dogs pull the average of the index down below its median.  In negative skewness the fewer stocks you hold the more likely you will outperform the index.

The empirical evidence is that there is positive skewness, thus you should hold more stocks.  So _Gordon _is right but I humbly suggest for the opposite reason.


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## Gordon Gekko (14 Jun 2018)

Which is easier Duke, to pick a winner or to avoid a loser? I dare say the latter.

I broadly agree with your point; in my view lone wolves such as ourselves cannot effectively run concentrated equity portfolios and succeed.


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## cremeegg (14 Jun 2018)

Duke of Marmalade said:


> The article states that the average growth of the S&P was 1.5% higher than the median growth.



If an investor correctly buys the market, ie buys each share in proportion to its market cap, then he or she receives the average return, not the median.


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## Duke of Marmalade (14 Jun 2018)

cremeegg said:


> If an investor correctly buys the market, ie buys each share in proportion to its market cap, then he or she receives the average return, not the median.


yep and that's why there is such a trend toward passive investment.  An interesting thought experiment is if everybody is a passive investor, who sets the price?


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## Sarenco (14 Jun 2018)

Gordon Gekko said:


> The more that I read up on this, the more my own view strengthens; basically, it’s mad to own less than (say) 30 shares.


It's not mad if your objective is to beat the market return.

Which is why I don't understand Brendan's question...


Brendan Burgess said:


> The main point for investors is whether 10 shares is enough.


Enough for what exactly?  Enough to achieve something akin to the market return?  Enough to materially reduce the idiosyncratic risk of individual stocks?  Enough to diversify accross sectors, geography, company size or something else.

Without knowing an investor's objective, it's an impossible question to answer.


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## john luc (15 Jun 2018)

just being reading here and curious but what criteria do ye apply when picking a stock. Do you use market cap, industry leader, management team,


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## Colm Fagan (15 Jun 2018)

Whilst I don't have any statistics to prove the conjecture, I am confident that a portfolio of 10 shares selected randomly from the top 100 shares in the world index, with weightings broadly consistent with their respective market valuations, would deliver the same return as the index with a margin of error of 1% in any 12 month period.  In the shorter term, more significant variations from the performance of the index are likely, but the longer the measurement period, the smaller the variation in annual percentage terms.  The experience of the "sloth fund", which I mentioned in posting #15 on this thread, supports this contention.  

A portfolio constructed on these lines has a number of  advantages.  Buying a small number of shares reduces the costs (assuming you're dealing with a broker that has a minimum fee irrespective of deal size).  You also get to understand the underlying businesses, which is vitally important from my perspective.  I cannot stand the idea of buying into businesses without having some idea what I'm buying into. I love to be able to identify with the companies and the major players in those companies.   I think 10 is about the most that an average private investor can get their heads around.  Of vital importance too is the fact that you save on investment management fees.   The saving would broadly equal the margin of error. 

Further advantages accrue over time.  As you get more familiar with the businesses, you can vary your weightings (gradually) to favour the companies that you have more confidence in.  I would not advise anyone to get to the levels of concentration I have now reached with some of the companies in my portfolio.   I recognise that I am definitely an outlier and I would not advise anyone to follow the approach I’ve taken, but it’s possible to achieve superior performance over time by shifting weightings on a gradual basis.


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## Sarenco (15 Jun 2018)

Colm Fagan said:


> The experience of the "sloth fund", which I mentioned in posting #15 on this thread, supports this contention.


Not really Colm.  The sloth fund was initially constituted with 30 (not 10) US "mega-caps".  If you established a portfolio with 30 of the largest cap companies from the S&P500 then, yes, the correlation with the S&P500 as a whole would be very high. 

However, these days ETFs that track the S&P500 have TERs of as low as 5bps so nobody bothers trying to establish a portfolio that acts as a proxy for the market anymore - they just buy the market!

10 stocks randomly selected from the ~10,000 publicly traded companies across the globe is not going to be anywhere near as closely correlated.


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## Colm Fagan (15 Jun 2018)

Sarenco said:


> 10 stocks randomly selected from the ~10,000 publicly traded companies across the globe is not going to be anywhere near as closely correlated.



I accept that the performance of the 10 stocks will definitely not be as closely correlated to the index as an ETF.  Sometimes it will perform slightly better than the index, other times slightly worse than it, but blind adherence to an index is not the primary goal as far as I'm concerned.  Far from it.  I cannot bear the thought of investing in companies where I cannot identify with the companies concerned.  That to me is an absolute no-no.  There’s no fun in it.  Like most other things in life, we should try to get some fun out of investing, to enjoy it.  I hope that my “Private Investor” postings show that investing can be exciting.   Also, as I said in my final paragraph, following those 10 companies over a number of years can help you identify which ones are superior performers and possibly more importantly, as Gordon Gekko noted earlier, which are potential laggards.  Those insights come, not from detailed technical evaluation of financials, but from the consistency of the message from the Board and senior management and from the language used.  You don’t have to be a financial genius.   Over the longer term, I am pretty confident that this strategy will deliver above-average performance, without costing you a cent in investment management fees.   Try it!!!


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## jpd (15 Jun 2018)

Duke of Marmalade said:


> An interesting thought experiment is if everybody is a passive investor, who sets the price?



I think about this too. Presumably there will always be enough active investors to move the price to it's "proper" value, whatever that is!


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## Duke of Marmalade (15 Jun 2018)

Colm Fagan said:


> Whilst I don't have any statistics to prove the conjecture, I am confident that a portfolio of 10 shares selected randomly from the top 100 shares in the world index, with weightings broadly consistent with their respective market valuations, would deliver the same return as the index with a margin of error of 1% in any 12 month period.


Colm,  that seems a very strong conjecture.  I know picking randomly from FTSE 100 is not directly comparable with your algorithm but it was the most available to a Google search.  I have uploaded my findings (I love uploading).  This is the current 12 month performance of the individual components.  I was really startled by the variance between companies.  No less than a staggering 29% standard deviation  In words, using say 2 standard deviations as a measure of outlier a single stock picked at random might be 60% off the average.  For 10 stocks chosen at random the standard deviation would be 9% with the outlier being a possible c.20% off the benchmark.


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## Colm Fagan (15 Jun 2018)

Duke, I guessed that you would be on the job!!   Yes, I'm surprised too by the differences.  Did you allow for weightings relative to their respective market capitalisations?  It would also be interesting to know if my related conjecture that the variation reduces over time holds true.  Can you look at those same stocks over (say) a three year period?  For completeness, we should look at total returns, not just price.


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## Duke of Marmalade (15 Jun 2018)

Colm Fagan said:


> Duke, I guessed that you would be on the job!!   Yes, I'm surprised too by the differences.  Did you allow for weightings relative to their respective market capitalisations?  It would also be interesting to know if my related conjecture that the variation reduces over time holds true.  Can you look at those same stocks over (say) a three year period?  For completeness, we should look at total returns, not just price.


Nothing as fancy as market weightings, and I think am using the FTSE price only index, but it gives a flavour of the concepts involved.  I upload the spreadsheet with 5 year figures included.  Yes the standard deviation falls from 29.2% to 11.8% but we would expect that order of reduction fro purely statistical considerations (divide by SQRT(5)).


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## Duke of Marmalade (15 Jun 2018)

forgot to upload


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## Colm Fagan (15 Jun 2018)

Duke
My conjecture isn't looking good at this stage, but hasn't been disproved - yet.   
I still hold with my other (subjective) contentions re being able to identify with the companies in which my money is invested, getting some craic from it, and being able to modify and improve the strategy as I become more familiar with the companies.   Remember that the investment horizon is at least 5 to 10 years, so there's plenty of time to get to know the companies and the people running them.


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## Duke of Marmalade (15 Jun 2018)

I'm almost in a state of shock over the variation between stocks in the FTSE 100.  The 12 month performance varies from -42% to +160% (ok +66% if we ignore the outlier Evraz).  I think of the index as being a relatively tame beast but underneath it is a sea of turmoil.


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## Sarenco (15 Jun 2018)

Duke of Marmalade said:


> I'm almost in a state of shock over the variation between stocks in the FTSE 100.


And that's just large caps - imagine the variation in returns across the full FTSE All-Share Index.

Unecessarily taking on the obvious risks of a highly concentrated 10-stock portfolio wouldn't be my idea of fun.  But each to his own I guess.


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## SPC100 (7 Aug 2019)

Irishtimes have an article about the research today









						Most stocks are flops: just 1% of stocks account for all market gains
					

Picking the handful of stocks that deliver the bulk of investor returns is seeking a needle in a haystack




					www.irishtimes.com
				




This looks to be the relevant original research papers for those interested in reading more









						Do Stocks Outperform Treasury Bills?
					

Four out of every seven common stocks that have appeared in the CRSP database since 1926 have lifetime buy-and-hold returns less than one-month Treasuries.  Whe



					papers.ssrn.com
				












						Do Global Stocks Outperform US Treasury Bills?
					

We study compound returns to nearly 62,000 global common stocks during the 1990 to 2018 period, documenting that the majority, 56% of US stocks and 61% of non-U



					papers.ssrn.com


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## Colm Fagan (8 Aug 2019)

@SPC100 Thanks for providing the links to the two articles mentioned.  I've downloaded them and hope to study them shortly.

I confess to an element of scepticism (based partly on my own experience of running a highly concentrated portfolio for almost two decades now).  I will study them with a jaundiced eye.

A couple of other reasons for being sceptical:
1.  Earlier in this thread, @Sarenco  alerted us to what is now called the "Voya Corporate Leaders Trust Fund".  This fund has been in existence since 1935 and has stuck with exactly the same stocks, unless they went bankrupt.  Only 22 of the original 30 are still standing.  All the money is in those stocks (allowing for the fact that some have been taken over, etc.).  The performance of that fund exceeded the return on the S&P 500 over the 40 years to 2016.  This is despite the fact that it would have missed out completely on all the glamour stocks - Microsoft, Amazon, Apple, etc.   It didn't even include IBM!   Does that square with this academic's conclusions?
2.  I looked at another academic study some time ago, which arrived at similar results to those quoted in the Irish Times article.  As I recall, it gave exactly the same weighting to a fly as to an 800-pound gorilla, which is nonsense.  Most small companies go bust in their early years.  I'm sure much the same is true for listed stocks.  To be true to real life, the study should allow for relative size and should also limit the universe to stocks that have been quoted for (say) five years.

A final comment is that such papers help to convince ordinary investors not to trust their own judgement when buying stocks.  I'm not surprised that an active asset manager gave financial support to one of the authors, but maybe that's just my suspicious mind!

Anyway, thanks again for posting the references to the papers, and I look forward to reading them.


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## Sarenco (8 Aug 2019)

Here's a link to the Vangurad paper referenced in the IT article (which is worth a read IMO) -


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## Sarenco (9 Aug 2019)

Colm Fagan said:


> @SPC100 The performance of that fund exceeded the return on the S&P 500 over the 40 years to 2016.  This is despite the fact that it would have missed out completely on all the glamour stocks - Microsoft, Amazon, Apple, etc.   It didn't even include IBM!   Does that square with this academic's conclusions?


Interesting question.

I think the original stock selection of the "sloth fund" is important.  The fund's promoters invested equally in the common stocks of the 30 biggest US companies (excluding financials) back in 1935.  Their central thesis was that if a company could survive the Great Depression, it could survive anything.  History has largely proved them right.

To put it another way, an extreme "quality screen" was applied to each stock selected.  If a company suspended dividend payments, it was dumped.

These were all companies with large competitive "moats".  The stock selection followed a formula - it was by no means random or subjective.

It is certainly true that the sloth fund has (modestly) outperformed the S&P500 over the last 40 years.  However, that is largely due to the fact that the fund holds practically no tech stocks and therefore avoided the worst of the 2000 tech crash.  Conversely, the sloth fund has materially lagged the S&P over the last 10 years (largely because it doesn't hold any FAANGS).

Will this outperformance be repeated over the next 40 years?  That's obviously possible but I have my doubts.

So, it's clear that the sloth fund is something of a poster child for the long term benefits of a buy and hold approach, while limiting transaction costs.

Does it jar with the academic research that indicates that market returns are generated by a small minority of stocks?  Well, I don't think so.

Incidentally, I entirely agree with your 2nd point regarding the market capitalisation of the universe of stocks under consideration.  I tried to make that exact point (albeit far less eloquently) earlier in this thread.


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## Brendan Burgess (10 Aug 2019)

Colm Fagan said:


> A final comment is that such papers help to convince ordinary investors not to trust their own judgement when buying stocks. I'm not surprised that an active asset manager gave financial support to one of the authors, but maybe that's just my suspicious mind!



I haven't read the papers yet, but I don't understand this point Colm.

If all the returns come from 1% or 2% of the shares, would it not  make it even more difficult for active fund managers to outperform?

If I believed these figures, then surely I should buy an ETF?  I need a few hundred shares to make sure I get the very few successful ones.

Brendan


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## Colm Fagan (10 Aug 2019)

Sarenco said:


> it's clear that the sloth fund is something of a poster child for the long term benefits of a buy and hold approach, while limiting transaction costs


Hi Sarenco. Firstly, thanks for an excellent post. I've picked out this quote, because it supports my basic contention that someone saving for retirement over (say) 20 years and then drawing down those savings over (say) the following 20 years is best advised to stick the money in a small number of good quality stocks and leave it there, reinvesting the dividends in the run-up to retirement, then taking the dividends plus gradual share sales for “income” in retirement.
This is a vastly superior strategy to the conventional wisdom from financial advisers, wealth managers and insurance companies that they should invest in a mix of equities/property, bonds and cash in the run-up to retirement, shifting gradually to less “risky” investments as retirement date approaches, and then either buy an annuity (i.e. put everything in bonds) or reduce the equity proportion substantially in the final 20 years, i.e. throughout their retirement.  The question of whether the long-term performance of their chosen stocks is slightly better or slightly worse than "the market" is of little significance relative to the high-level equity/bond/cash asset allocation question.

And this conclusion is even before allowing for asset management fees and other charges.  From what I've seen, some of the charges on post-retirement products are quite excessive.



Brendan Burgess said:


> If all the returns come from 1% or 2% of the shares, would it not make it even more difficult for active fund managers to outperform?
> 
> If I believed these figures, then surely I should buy an ETF? I need a few hundred shares to make sure I get the very few successful ones.




Brendan, I see your point, but I think the authors (more likely, their asset manager sponsors) are trying to frighten off DIY investors, to convince them that they need “professional” help in choosing investments.  My views on this subject are set out in the diary entry “A guy in the attic”.


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## Duke of Marmalade (10 Aug 2019)

Sarenco said:


> Here's a link to the Vangurad paper referenced in the IT article (which is worth a read IMO) -


I read it.  Mostly common sense and not really needing 10,000 simulations.
The glaring mathematical fallacy of Figure 5 rather devalued the whole paper for me.  And it is fairly central to the message.  For example it says the average expected excess return (AEER) for a 1 stock random portfolio is -9.9% compared to a fully diversified approach.  But the math of the simulation algorithm would dictate that the AEER should be zero no matter what size of portfolio.
So where is the error? The paper splits the simulations into those with positive excess return which for the 1 stock portfolio occurs on 11.1% of occasions with a conditional average excess return of +4.2%.  Conditional average excess returns on the 88.9% simulations which underperfomed was -11.7%.  The paper then gets the weighted average of these figures which is indeed -9.9%.  But that is false math.  What should have been done is to find the weighted average of the two returns rolled up for 41 years and then find what the equivalent annual return is over those 41 years.  Within rounding the AEER at all portfolio sizes is, as the math would dictate, zero.

Another piece that stuck in the craw:


			
				Vanguard said:
			
		

> We found that less diversified portfolios have more relative risk than more diversified ones and that investors should therefore expect higher returns from the less diversified portfolios, but the evidence from our simulations shows that concentrated portfolios have lower average returns than diversified portfolios.


Besides the fact that (see above) the evidence does not show this last at all, they really do show a basic misunderstanding of financial theory here.  Risk is not rewarded as a moral imperative!!  Of course concentrated portfolios are more risky than diversified ones but, so the theory goes, this risk can be avoided (by diversifying).  There is no basis whatsoever for expecting a risk that can be avoided to be rewarded by the market.


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## Colm Fagan (10 Aug 2019)

I don't know if readers of this forum realise how lucky we are.  Vanguard is one of the most highly regarded asset management companies in the world.  It works hard to maintain its reputation. I presume this paper went through a thorough internal peer review process and that its conclusions are being quoted as gospel worldwide, yet here is one of our own demolishing a couple of its key arguments.  Thanks @Duke of Marmalade !


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## Sarenco (12 Aug 2019)

Duke of Marmalade said:


> Of course concentrated portfolios are more risky than diversified ones but, so the theory goes, this risk can be avoided (by diversifying). There is no basis whatsoever for expecting a risk that can be avoided to be rewarded by the market.


Very fair point Duke.

Still, I thought the simulated portfolios' probability of outperforming the (equal weighted) benchmark, based on historical data, was interesting nevertheless.  For example, the finding that a (randomly selected) 30 stock portfolio had a 40.3% probability of outperforming the benchmark is much closer to a coin toss then I would have predicted.


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## Duke of Marmalade (12 Aug 2019)

Sarenco said:


> Very fair point Duke.
> 
> Still, I thought the simulated portfolios' probability of outperforming the (equal weighted) benchmark, based on historical data, was interesting nevertheless.  For example, the finding that a (randomly selected) 30 stock portfolio had a 40.3% probability of outperforming the benchmark is much closer to a coin toss then I would have predicted.


_Sarenco_, this paper and in particular Figure 5 really got me thinking (so yes it was worth a read), in fact it got me doodling on Excel.  The latter part of the paper showing, for example, that a 52% success rate (as defined) in picking stocks gives fairly significant out performance expectations surprised me and may be of some interest, though I haven't subjected the methodology to much scrutiny. 
But the whole earlier part of the paper is vacuous.  All the simulations are showing is what are statistical truisms.  The results are in no way dependent on sampling historic data.  Figure 2 and the fact that outliers dominate the benchmark is not necessary to come up with these truisms.  If we sampled from a perfectly well behaved data set where all stocks show the same distribution we would still find that the smaller the portfolio size the greater the dispersion.  More importantly, whilst the expected overall return is the same for all portfolio sizes the probability of being higher than the expectation is lesser for the smaller portfolios.  But since it is an expectation there is clearly a compensation for having less chance in achieving your expectation in having a higher chance of shooting the lights out. 
I repeat that these observations would be true no matter what distribution you chose for the population you are sampling from, they are totally independent of past data.
Just to get a bit wonkish here, the reason for these truisms is the Central Limit Theorem.  In effect the methodology is producing a Lognormal distribution of the final returns and from this the truisms follow.  The Central Limit Theorem essentially smooths away any idiosyncracies in the underlying data set that is being sampled.


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## Sarenco (12 Aug 2019)

Duke of Marmalade said:


> If we sampled from a perfectly well behaved data set where all stocks show the same distribution we would still find that the smaller the portfolio size the greater the dispersion.


Sure but all stocks didn't show the same distribution so surely the historic data impacts the degree to which the dispersion narrows as the number of stocks increases.  No?


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## Duke of Marmalade (12 Aug 2019)

Sarenco said:


> Sure but all stocks didn't show the same distribution so surely the historic data impacts the degree to which the dispersion narrows as the number of stocks increases.  No?


Yes, that is true.  But if the Central Limit Theorem applied in full the only parameter of the dispersion that matters would be the variance.  And yes outliers do increase variance, but the skewness they impart is planed away by the CLT.
In this particular example the CLT is not fully applicable as the different quarterly rebalancings are not from iids.  Nonetheless I would suggest that the variance dominates the dispersion of the final outcomes.  
I wonder is it possible to access the Vanguard database.


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## RobFer (13 Aug 2019)

Colm Fagan said:


> I don't know if readers of this forum realise how lucky we are.  Vanguard is one of the most highly regarded asset management companies in the world.  It works hard to maintain its reputation. I presume this paper went through a thorough internal peer review process and that its conclusions are being quoted as gospel worldwide, yet here is one of our own demolishing a couple of its key arguments.  Thanks @Duke of Marmalade !


I understand there is good reason to be sceptical but there is a hierarchy in finance research too.


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