Diversifying our stock portfolio(s)

[Deleted User]

Prism said:

JohnWinder said:

Bessembinder, Hendrik (Hank), Do Stocks Outperform Treasury Bills? (May 28, 2018). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=2900447 or http://dx.doi.org/10.2139/ssrn.2900447

'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. When stated in terms of lifetime dollar wealth creation, the best-performing four percent of listed companies explain the net gain for the entire U.S. stock market since 1926, as other stocks collectively matched Treasury bills. These results highlight the important role of positive skewness in the distribution of individual stock returns, attributable both to skewness in monthly returns and to the effects of compounding. The results help to explain why poorly-diversified active strategies most often underperform market averages. '

What is interesting is the Baillie Gifford use that paper as one of their main tenants of their style of active investing. Try and find the 4% or in fact the less than 1% that generate most of the returns.

Looks like a plan. 
Although advocates of "rebalancing", "top-slicing," indeed "diversification" will dilute most the potential gains that way.

Linton

ZingPowZing said:

Prism said:

JohnWinder said:

Bessembinder, Hendrik (Hank), Do Stocks Outperform Treasury Bills? (May 28, 2018). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=2900447 or http://dx.doi.org/10.2139/ssrn.2900447

'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. When stated in terms of lifetime dollar wealth creation, the best-performing four percent of listed companies explain the net gain for the entire U.S. stock market since 1926, as other stocks collectively matched Treasury bills. These results highlight the important role of positive skewness in the distribution of individual stock returns, attributable both to skewness in monthly returns and to the effects of compounding. The results help to explain why poorly-diversified active strategies most often underperform market averages. '

What is interesting is the Baillie Gifford use that paper as one of their main tenants of their style of active investing. Try and find the 4% or in fact the less than 1% that generate most of the returns.

Looks like a plan. 
Although advocates of "rebalancing", "top-slicing," indeed "diversification" will dilute most the potential gains that way.

Baillie Gifford have the resources and expertise to attempt this.  You as a private investor dont stand a chance.

But there is a downside.  In 2007 the BG flagship IT, Scottish Mortgage, fell by about 60%.  If you are just playing with investing with a very small investment pot then you can just shrug your shoulders, easy come easy go.  However if you are investing your life savings perhaps you may take a different view.

[Deleted User]

Linton said:

ZingPowZing said:

Prism said:

JohnWinder said:

Bessembinder, Hendrik (Hank), Do Stocks Outperform Treasury Bills? (May 28, 2018). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=2900447 or http://dx.doi.org/10.2139/ssrn.2900447

'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. When stated in terms of lifetime dollar wealth creation, the best-performing four percent of listed companies explain the net gain for the entire U.S. stock market since 1926, as other stocks collectively matched Treasury bills. These results highlight the important role of positive skewness in the distribution of individual stock returns, attributable both to skewness in monthly returns and to the effects of compounding. The results help to explain why poorly-diversified active strategies most often underperform market averages. '

What is interesting is the Baillie Gifford use that paper as one of their main tenants of their style of active investing. Try and find the 4% or in fact the less than 1% that generate most of the returns

You as a private investor dont stand a chance

“You as a private investor don’t stand a chance.” News to me. 

Helps to be lucky, of course, but not that lucky..
..minimum diversification of common stock holdings whereby  the investor is likely to exceed the benchmark in the historic example above is three.

Of course there may be a reckoning coming in the way of a 60% correction, which only underlines the good practice of not squandering gains during the good years.

thegentleway

ZingPowZing said:

JohnWinder said:

'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. 

Interesting statistic.
So investment in one individual common stock would probably have underperformed the benchmark (Treasuries). Given this likelihood, and the certainty that buying all XXXX common stocks would have exceeded the benchmark, the question is What is the number of holdings that would make exceeding the benchmark more likely than not?
The answer, surprisingly, is three.

Although personally I wouldn't be comfortable holding less than three stocks, the two held by Langtang seem well suited to his requirements until retirement. If others identify growth stocks that also pay 5% dividends, please let us know.

How did you work out it’s 3?! 

[Deleted User]

Probability of picking three stocks over benchmark: 3/7 x 3/7 x3/7 = 27/343
Probability of picking three under benchmark           4/7 x 4/7 x 4/7 = 64/343
Probability of picking two stocks under benchmark     4/7 x 4/7 x 3/7 x 3 = 144/343
Probability of picking two stocks over benchmark       4/7 x 3/7 x3/7 x 3 = 108/343

We know from the paper that if we strip out the 4% of highest-flying stocks; the 38% of stocks that measured positively against the benchmark balanced the 58% that didn't, which means that a positive stock has a +/- value 50% higher than a negative - on the whole. So, where a portfolio consists of two negative and one positive stock, half would still be positive overall. * Whereas, chances of one negative outweighing two positive stocks is one in nine.

So,  27 + 72 + 96 = 195/343 (or 57%) probability of exceeding the benchmark with a portfolio of three. 
There again, if we continue to exclude the top 4%, then the higher the sample, the nearer to 50% the probability should become; so I may well have missed something important from these fag-packet calculations. But I think they land in the right area (we're a long way from the hundreds and thousands approach) and, of course, the top 4% would not be excluded from our portfolios in reality. 

EDIT:* I made an error here, giving a value of 150 to a stock in positive territory, against 100 for a negative. The values should be 123 and 82. So the probability of beating the benchmark with a three stock portfolio is c 40%, rising to 50% on a portfolio that covers the whole market.

Prism

ZingPowZing said:

Probability of picking three stocks over benchmark: 3/7 x 3/7 x3/7 = 27/343
Probability of picking three under benchmark           4/7 x 4/7 x 4/7 = 64/343
Probability of picking two stocks under benchmark     4/7 x 4/7 x 3/7 x 3 = 144/343
Probability of picking two stocks over benchmark       4/7 x 3/7 x3/7 x 3 = 108/343

We know from the paper that if we strip out the 4% of highest-flying stocks; the 38% of stocks that measured positively against the benchmark balanced the 58% that didn't, which means that a positive stock has a +/- value 50% higher than a negative - on the whole. So, where a portfolio consists of two negative and one positive stock, half would still be positive overall. Whereas, chances of one negative outweighing two positive stocks is one in nine.

So,  27 + 72 + 96 = 195/343 (or 57%) probability of exceeding the benchmark with a portfolio of three. 
There again, if we continue to exclude the top 4%, then the higher the sample, the nearer to 50% the probability should become; so I may well have missed something important from these fag-packet calculations. But I think they land in the right area (we're a long way from the hundreds and thousands approach) and, of course, the top 4% would not be excluded from our portfolios in reality. 

As long as you realise what the benchmark is in this scenario - its cash. Thats the point that 4 out of 7 don't even beat a cash return and 3 out of 7 do beat cash. Not a very high bar to beat. To actually pick a stock that makes any real money is as reported 4% or about a 1 in 25 chance. Of course that assumes you hold forever which is actually unlikley.

[Deleted User]

The paper says one month Treasuries. 
They pay something .
They cannot be saying that holding cash beats an investment in most shares. 

Prism

ZingPowZing said:

The paper says one month Treasuries. 
They pay something .
They cannot be saying that holding cash beats an investment in most shares. 

One month treasuries are pretty much cash. Currently for example they pay the equivalent of 0.04%
They are really saying that - most equities over the long term return less than cash.

[Deleted User]

Prism said:

ZingPowZing said:

The paper says one month Treasuries. 
They pay something .
They cannot be saying that holding cash beats an investment in most shares. 

One month treasuries are pretty much cash. Currently for example they pay the equivalent of 0.04%
They are really saying that - most equities over the long term return less than cash.

Is that consistent with the returns from Treasuries since 1926, Prism? I'll take your word for it.

But even if that is the case, the dataset of common stocks in this paper is 25,300. The dataset of stocks in most portfolios appears on one page of a daily newspaper, nearly all beat cash. 

But even if 4/7 of popular shares proved to be worse investments than cash, the likelihood of exceeding the benchmark with a handful of shares is nothing like as slim as most diversification strategies imply. 

Locating growth stocks is not difficult and it is not random but, if it were, no amount of diversification will improve overall returns, just bring them closer to the average.

AnotherJoe

Relying on oil for your pension.
Not the best plan IMO.