August 17, 2010
The much higher returns generated by the eight-stock portfolio over the past 20 years are not something that we can count on persisting. Historical performance of portfolios is a notoriously poor predictor of future performance. I have run a forward-looking Monte Carlo model to provide for a more realistic assessment of reasonable expected returns.
The Monte Carlo model that I developed, QPP, is consistent with the idea that expected return scales with total risk, not just beta risk. The Monte Carlo projections are shown below:
These projections still suggest a substantial benefit to the equal-weighted eight-stock portfolio over the S&P 500, but the expected future benefit is much lower than the differential was over the last 20 years.
When I run the Monte Carlo using data through July 2007, before the crash, those projections also expected notable outperformance from the equally weighted eight-stock portfolio. Over the three years from August 2007 through July 2010, that portfolio provided an average return of about 8.5% per year, as compared to about -5.0% per year for the S&P 500.
These results do not imply that a portfolio with this small a number of stocks is optimal or even a good idea. All models are imperfect. Limitations in models (in general) can partly be accounted for by taking a larger number of positions. The point of showing these calculations is to demonstrate how a world view in which total risk (market risk plus idiosyncratic risk) determines expected returns will clearly lead to different portfolio strategies than a world view based on CAPM or factor models.
Implications
While CAPM and its successors created a powerful reason to use market-capitalization-weighted mutual funds, the newer research makes a case for portfolios that hold significant idiosyncratic risk. These portfolios will tend to be lower-beta (because we no longer believe that beta is necessary for higher return), and there is no reason for them to hold hundreds of stocks.
Portfolios with smaller numbers of stocks are naturally exposed to higher default risk. Investors can reduce default risk by carefully screening stocks on the basis of their volatility. By setting a reasonable upper-bound on the volatility of individual stocks, the probability of selecting the stock of a company that will go bankrupt declines markedly.
There is a tradeoff between market risk and company-specific risk in portfolios with smaller numbers of stocks. A portfolio with a large number of holdings is more exposed to default risk, but the benefit of holding individual stocks is that we can exploit the relatively lower correlations among them to create a low-beta portfolio with attractive expected return.
Based upon the research into idiosyncratic risk and return, it is not possible to argue that a carefully selected portfolio of 20 individual stocks is inherently inferior to an index fund. While index funds remain the best solution for many investors, we will see increased focus on portfolios that hold far smaller numbers of stocks than the total market, but which can outperform an index fund on an absolute and risk-adjusted basis. A portfolio holding a good selection of Dividend Aristocrats, typically high-quality stocks with low-to-moderate betas and volatility, can be expected to continue to outperform. That said, individual investors should not simply rush out and buy a handful of individual stocks as soon as they finish reading this article – intelligent selection is required.
While many advisors and investors remain stuck in the old paradigm that idiosyncratic risk has no value and should be minimized, research over the last decade has discredited that dogma. Investors and advisors who believed that they need to add market risk (via higher beta) in order to achieve higher returns have ended up amplifying their exposure to systemic risk, with costly consequences. There has never been a more opportune time to stop and reconsider the conceptual models that motivate our investing decisions.
Geoff Considine is the author of a new book, Survival Guide for a Post-Pension World, as well as a book on the use of options strategies in wealth management. More information is available at www.quantext.com.
Geoff’s firm, Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com), an innovative brokerage firm specializing in offering and trading portfolios for advisors and individual investors.
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