Diversification Is Greater Than Concentration

Why own the entire S&P 500 when the top 10 stocks are driving returns? 

Matthew Bartolini says diversification outplays concentration and he provides the charts to back it up.

Why own the entire S&P 500 when the top 10 stocks are driving returns, why just not own the top 10?

This question from an audience member at a recent conference I spoke at got right to the heart of the market concentration narrative that’s been so dominant over the past few years.

My response: Concentrated market returns are timely; diversification is timeless. And here are the charts I had in my memory bank.

Diversification Has a Strong Record Over Concentration

There is no better data than the return streams from the Kenneth R. French Data Library from the Tuck Dartmouth School of Business (French data) for studying market returns. We used these time series in our highly informative sector business cycle research and will use them here as well.

Concentrated portfolios are identified by the French data returns for the top 10%, top 20%, and top 30% of the market. The market is defined by adding back in the risk-free rate from the r_m – r_f factor from the French data.

Based on this data, the diversified market has outperformed each of the more heavily concentrated portfolios since 1926. And the most concentrated portfolio posted the lowest return — a still respectable 9.84% annually, but below the market’s 10.14%.¹

That 30 basis points a year difference translates into meaningful wealth accumulation over time. One dollar invested in the market in 1926 is worth $12,930 today (not adjusted for inflation) versus just $9,855 for the top 10% portfolio (Figure 1). That’s a 24% increase in wealth for the “diversified” investor.

Of course, the 1926 purchase date applies only to investors 98-years old and over. Kudos if that’s you. To compare a more realistic holding period, we analyzed 10-year rolling returns of the same portfolios.

Under this 10-year rolling scenario, the diversified market portfolio beat its concentrated counterparts most of the time. The market beat the top 10% portfolio 66% of the time — or on 701 occasions over 1,056 rolling 10-year windows. And the market outperformed the top 10% portfolio by an average 0.52% per year. This outperformance was consistent across the other portfolios as well (Figure 2).

The same analysis holds true even under shorter rolling periods, as the “diversified” market outperforms the top 10% portfolio in 53% of the 1,128 rolling 5-year periods with an average 0.33% per year excess return since 1926.² The hit rate is also above 50% for the other portfolios, and the average excess return is also positive.³

Concentration Has Its Day, Then It Doesn’t

Plotting the average excess returns on a time series helps illustrate how concentrated portfolios can have their day in the sun, but that diversification wins out over the long run. The market’s rolling 10-year annualized excess returns versus the top 10%, 20%, and 30% portfolio are plotted in Figure 3.

While there are times when concentration wins out (like in the 90s and now), the peaks for diversification are higher than the peaks are for concentration. And investors who fled diversified portfolios in the 90s to chase the hot dot of concentration underperformed the more diversified market over the next 174 consecutive rolling 10-year return periods.⁴

To be fair, there are times, like now, where concentration goes on a bit of winning streak. However, over a rolling 10-year time frame, diversification, has had more consistent streaks. And if the concentrated portfolio goes on a run, its reign of dominance more reliably mean reverts. For example, the diversified portfolios have an average streak of 38 consecutive rolling 10-year periods where their returns are greater than the concentrated top 10% portfolios.⁵

The concentrated portfolio has an average streak run of just 18 periods,⁶ illustrating the staying power and longevity of diversification even though concentration can, at times, steal the limelight. This is also evident when looking at annual returns.

Since 1926, the diversified portfolio has outperformed concentrated portfolios (10%, 20%, and 30%) more than half the time on an annual basis. Diversification wins out most of the time over this near-full century of returns, and by more than 0.55% per year for the most concentrated portfolio (Figure 4).

Diversification Is a Timeless Tune for Portfolios

There is a reason why The Beatles, Miles Davis, and the classical likes of Johann Sebastian Bach are still listened to today. Their genius transcends eras, creating a timeless appreciation even when the latest craze tries to flex its muscle.

Sure, back in the 1990s Vanilla Ice and Ricky Martin grabbed some airtime right as the concentrated portfolio was doing the same. But remember that diversification is like Bach’s Concerto in D Minor for Two Violins — it continues to outlast and transcend the latest hot dot or one hit wonder. After all, the This Is Bach Spotify playlist has more than 600,000 saves while This is Vanilla Ice has 9,000.⁷

Market sentiment often hinges on front-page headlines, but digging into the data often reveals meaningful surprises. For more market commentary and our latest insights read our Midyear Market Outlook.