We all know diversification is important. But it’s always nice to be reminded just how important it is – and even better when you have news articles linking directly to academic papers like this one does.
Hendrik Bessembinder, a researcher at Arizona State ran a really interesting analysis.
If you look at individual stocks in the US from 1926 until 2015 (pretty much all of the reliable stock data that exists for US companies), he found that only 42% of companies outperformed one-month US Treasury bills – generally considered to be a risk-free investment – over their lifetimes.
In other words, if you were to pick a stock randomly, there’s close to a 60% chance you would be better off pretty much just walking away. The results don’t get much better if you start looking at it on a monthly basis, either.
It just keeps getting worse, though. Over that same period, only eighty-six stocks generated about half of the total market returns. I can keep quoting the statistics (they just keep getting better), but just take a look yourself.
What this really drives home is one of the visceral whys of diversification. Imagine that you missed out on just one of the stocks that drove the market returns? You would have missed a massive portion of the returns that you deserved to get for taking on that market risk.
The thing is, we have no way of knowing which stocks will generate these returns going forward. There’s no guarantee that companies that have done well in the past will continue to do so.
If Bessembinder had stopped his analysis in the late 90s, I’m sure Enron and Worldcom would have shown up as some of the main drivers of market returns.
That didn’t turn out so well…
The market is always changing, and always reacting to what is happening next. There’s always some reason that a single company looks like it’s poised to take off or fall apart. And the same applies to the markets as a whole.
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