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Concentrated Portfolios Are Dangerous

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Concentrated Portfolios Are Dangerous by Stephen Aust, MarketCycle Wealth Management

The newest investment fad is called “CONCENTRATED INVESTING” and there is even a new book that just came out on the subject.  The idea is to pick a tiny handful of the best stocks, the few that are going to go up one-zillion-percent in one month, and to shun the rest.  Intuitively, most people would understand that this would be a dangerous proposition that is fraught with difficulty, however the idea is rapidly gaining in popularity as people re-forget that the tortoise beats the hare and with much less effort.  Concentrated investing is the exact opposite of holding a much lower-risk diversified portfolio.

According to J.P. Morgan, since 1980 (in the Russell 3000):

  1. Almost half of all stocks have suffered a PERMANENT loss of more than 70%.
  2. The return on the average stock has been a 54% loss.
  3. 66% of all stocks have had a negative absolute return.
  4. The number of historically outperforming stocks is only 7% and this leaves a 93% chance of picking an average or underperforming or collapsing stock.
  5. Numerous studies show that full-time professional stock analysts are correct only 6% of the time and this fact doesn’t leave the rest of us much hope of success with concentrated investing.

The stock market can be broken down into 10 different sector classifications and each stock will naturally fall into one of these sectors.  The percentage of stocks (per sector) that have experienced “catastrophic loss” of greater than 70% since 1980 are shown below (chart courtesy of J.P. Morgan):

Concentrated Portfolios

Concentrated portfolios – MarketCycle’s thoughts:

  • If you own a stock it simply means that you are part owner in the company that issued the stock.
  • Stock ownership can be the low risk pathway to great wealth.
  • A larger diversified portfolio of stocks has substantially less risk than holding just a few companies.
  • With stocks, sector selection (based on which part of the market cycle we are in) is more important (and more profitable on a risk adjusted basis) than is individual stock selection.
  • A “sector,” such as the “technology sector,” could hold a hundred different viable tech stocks, providing important diversification and “safety in numbers.”
  • So, in our opinion investors should be concentrated into carefully selected stock SECTORS (based on the market cycle) and not individual stocks.  ETFs are perfectly designed for this purpose.
  • It is impossible to consistently know in advance which individual stocks will outperform… it is only hindsight that is 20/20.
  • Regression to the mean causes individual high-flying stocks to eventually fall and it also causes weak, unpopular stocks to rise.  This is one important reason why a larger grouping of stocks, over the intermediate and longer-term, will likely beat a portfolio that only holds a handful of stocks.
  • A stock index such as the S&P-500 will exhibit prolonged and profitable directional trending behavior while an individual stock is ultimately random in its price moves.  Stock sectors, just like a stock index, will also trend.
  • The odds of consistently picking the few top performing stocks is very close to 0%; investors easily delude themselves into believing that they are better at this activity than they actually are.  Our brains are designed to remember past successes (and to tell others) but to forget the much larger number of past failures.
  • With stock picking, even investment professionals and stock analysts are not as good at hitting the target as they may believe.

Concentrated Portfolios Are Dangerous

Posted before the market open on April 25, 2016:  This chart shows the stock market over the past 1.5 years and the difficult and volatile sideways period that investors have had to endure.  Thank goodness that this scenario is ALWAYS a temporary phenomenon and that bad times ALWAYS lead to good times and that the stock market has a built-in longer-term upside bias:

Concentrated Portfolios

* MarketCycle’s client accounts are long (bullish):

  1. U.S. and developed market stocks (certain sectors)
  2. Floating-rate:  corporate bonds, senior bank-loans and preferred shares
  3. U.S. Treasury TIPS
  4. Physical gold bullion and commodity producers

* MarketCycle’s client accounts are short (bearish):

  1. Euro currency

* We are currently NOT hedged.

* The next meandering upside TARGET for the S&P-500 is 2375-ish.  The recent prolonged sideways markets and multiple corrections have let off any overbought pent-up steam that had built up in the stock market.  There are currently trillions of dollars sitting on the sidelines waiting to come back into the stock market… and this money will eventually flow back toward stocks.  The recent speed-bump lies behind us and the road ahead is relatively clear of obstructions (although the market will not move in a straight line, it will zig-zag as always).  We’re entering the late-stage of the market cycle but there is still plenty of cruising time before the next recessionary road-block.  It is also possible for recessionary periods to be highly profitable and yes, recessions can be spotted while they are still on the horizon.  Currently the calculated chance of a recession two months out is less than 5%.

Thank you for reading!

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