Odds Overwhelmingly Favor Diversification Over Stock Selection

Which is more appealing: a high probability of earning a good return or a small chance of earning a phenomenal one? Before you answer, you might consider the findings of a paper recently published by Hendrik Bessembinder, professor of finance at Arizona State University.

The paper’s title, “Do Stocks Outperform Treasury Bills?” is certainly provocative. One-month Treasuries, or T-Bills, are cash equivalents widely regarded as risk-free. Stocks, on the other hand, represent the opposite end of the risk spectrum. The paper, therefore, addresses a question fundamental to investing; are investors indeed compensated for bearing the additional risk associated with owning stocks?

The study analyzed 90 years’ worth of monthly returns for all U.S. stocks. Bessembinder estimates from 1926 to 2015, total U.S. stockholder wealth increased by a staggering $32 trillion. This return was assured to any investor who simply owned all U.S. stocks all the time.

Bessembinder’s shocking discovery is the market’s growth was fueled by just 4% of all publicly-traded companies. The remaining 96% just matched the return of T-Bills. Think of the implications! Investors who owned only a handful of stocks were very likely to be disappointed. With the odds of stumbling upon a rare winner so low, it’s more probable investors’ portfolios were filled with losers—stocks that failed to outperform cash.

Make no mistake: as a group, stocks do outperform T-Bills. But with almost 60% of stocks delivering returns below T-Bills, the returns realized from investors’ picking and choosing among stocks is another matter entirely.

Bessembinder’s research adds even more weight to the established wisdom of diversification, as well as clarifying its proper definition. To fully diversify all stock-specific risk, one must own all stocks. This is the only way to ensure capturing the top performers and to consistently harness stocks’ power for growth.

This brings us back to our original question. Armed with Bessembinder’s discovery that most stocks underperform cash, and the top 4% deliver all the excess return, which is more appealing—a probable good return or a possible amazing one?

Vista’s answer may come as no surprise. Built with index funds from Vanguard and asset class funds from Dimensional, our stock portfolios contain 12,000 companies diversified across 44 countries around the globe.

When it comes to our clients’ life savings, probable trumps possible 100% of the time.

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