Diversification could be the holy grail to successful investing over a medium long-term time, which is something you may have learned the hard way.
You might get lucky picking a few stock winners, but if those wins make you believe you are a stock wizard, able to invest in the latest stock winners, chances are you will give back your profits and maybe even lose your capital.
Think about it. If Warren Buffett was clueless in the 1990s about what stocks would make the Magnificent Seven in the 2020s, then what chance do you have of backing the winners?
“If Warren Buffett was clueless in the 1990s about what stocks would make the Magnificent Seven in the 2020s, then what chance do you have of backing the winners?”
WIN INVESTING
A diversification strategy is a way of riding future winners
Hendrik Bessembinder, a finance professor at Arizona State University, published a paper noting that despite the equity market gains from 1926 to 2018, those returns are driven by the few, not the average.
So the Nifty Fifty, a group of 50 large-cap stocks on the New York Stock Exchange that were most favoured by institutional investors in the 1960s and 1970s.
The Nifty Fifty stocks had consistent earnings growth and high P/E ratios.
Examples of Nifty Fifty stocks included household names such as General Electric, Coca-Cola, Polaroid. and IBM.
The Nifty Fifty stocks were known as one-decision by market analysts and financial academics, and all an investor has to do is buy and hold them forever.
For the boomer generation, Xerox was synonymous with taking a photocopy, and a Kodak moment referred to a touching moment deserving of taking a photograph.
“The Nifty Fifty stocks had consistent earnings growth and high P/E ratios”
WIN INVESTING
For Generation Z, Xerox and Kodak are meaningless, just like google it, would be Double Dutch for the same age group in the 60s, 70s and 80s.
So disruptive technologies would have made buying and holding the likes of Xerox and Polaroid, part of the Nifty Fifty, today defunct companies, a losing investment strategy.
Diversification is better than backing winners today
Hendrik Bessembinder’s paper noted that an extremely narrow group of stocks drove equity market returns.
Moreover, from 1926 to 2016, 32 trillion dollars of wealth generated by the stock market was due to 4% of businesses.
“in 2024, The Magnificent Seven are all lagging behind the benchmark indexes in 2024 and could be losing momentum”
– Win Investing
To make matters even more complicated, those winners keep changing.
Picking the next Amazon, Google, or Nvidia is as unpredictable and random as forecasting the future over the next decade.
We can not even predict what will happen next week, let alone next decade.
So if just 4% of stocks between 1926 and 2016 contributed 32 trillion dollars of wealth, other stocks must have underperformed.
In fact, out of the 500 companies in the S&P 500 as of October 1990, only 302 are still in existence 10 years later.
Recency bias, backing today’s winners, is not a winning investment strategy. Holding the winning Nifty Fifty into the millennium would have been a loss-making strategy.
Similarly, Magnificent Seven stocks, seven of the largest and most influential tech companies globally. Apple, Microsoft, Amazon, Alphabet (Google’s parent company), Meta (formerly Facebook), Nvidia, and Tesla were a profitable investment in 2023, up more than 60%.
But in 2024, The Magnificent Seven are all lagging behind the benchmark indexes in 2024 and could be losing momentum.
Diversification through buying the index, sectors and exchange-traded funds
So if only a handful of companies win and that handful changes constantly, how are we meant to decide what to buy?
The S&P returns over the past 100 years produced a return of 10.5% before inflation.
For example, an investment of 200 dollars a month for 40 years at those rates of return will produce a pot of 1.5 million USD on deposits of 96,000 dollars.
In conclusion, it is best not to focus on trying to pick the winners and buy low-cost index funds.
“In times of geopolitical uncertainties, it is wise to be globally diversified” – Win Investing
As noted above, the Magnificent 7, perceived as a sure bet, were up a staggering 60% in 2023, but could they end up performing like the Nifty Fifty in three decades?
Coca-cola and Exon were the best bets in the 1990s, but not so in the 2020s
Power law distribution and diversification strategy to capture the median returns
Power law distributions explain the composition of stock market returns over long periods. Stock market returns over the long term are not driven by most stocks but rather by a small number of structural growth businesses.
The extraordinary returns from this small number of structural growth businesses result in the market’s return distribution having a positive skew rather than a normal bell curve shape.
It is the compounding impact of high-return structural growth businesses (“the winners”) that drive most stock market returns over the long term.
An investor can beat the index and produce alpha if they can predict long-term winners buy and hold and give significant weight to them in their portfolio.
But as noted, this is extremely difficult to do.
Alternatively, market participants, including fund managers, can attempt to outperform over short periods using active trading strategies.
However, short-term trading and speculating become even more challenging in rising geopolitical tension, economic headwinds and when asset prices are a function of central bank monetary policy and not price discovery.
Global diversification long-term winning strategy
Diversification is not just about stock indexes and spread across sectors but also being globally diversified.
In times of geopolitical uncertainties, it is wise to be globally diversified.
So, if you invest in a global index fund, you have a 51% chance of making money, which is like tossing a coin, picking any day.
Now, pick any day and invest over three months instead, and your odds of making money will rise to 65%.
If you increase that period to a year, your odds go up to 73%, and ten years or more, 93% of making profits.
Global Index fund with a 10-year time horizon best odds of winning.
