Why Diversification Matters
The research, as cited in the aforementioned June 2017 post, shows that most common stocks (more than four out of every seven) do not outperform even virtually riskless one-month Treasury bills over their lifetimes.
The research also shows that individual stock returns exhibit a high degree of positive skewness (lotterylike distributions), meaning a very small percentage of outperforming stocks account for the large majority of returns.
For example, one study that covered the 90-year period ending in 2015 found that 96% of stocks just match the return of riskless one-month Treasury bills. The implication is striking: While there has been a large equity risk premium available to investors, a vast majority of stocks have earned negative risk premiums.
The study’s finding demonstrates just how great the uncompensated risk is that investors who buy individual stocks, or a small number of them, accept—risks that can be diversified away without reducing expected returns.
Such evidence highlights the important role of portfolio diversification. Diversification has been said to be the only free lunch in investing. Unfortunately, most investors fail to use the full buffet available to them.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.