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How to Increase the Odds of Owning the Few Stocks that Drive Returns

Chris Tidmore, Francis M. Kinniry, Giulio Renzi-Ricci and Edoardo Cilla
The Journal of Investing December 2019, 29 (1) 43-60; DOI: https://doi.org/10.3905/joi.2019.1.103
Chris Tidmore
is a senior investment strategist with The Vanguard Group in Malvern, PA
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Francis M. Kinniry Jr.
is a principal and global head of portfolio construction with The Vanguard Group in Malvern, PA
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Giulio Renzi-Ricci
is a senior investment strategist with The Vanguard Group in London, UK
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Edoardo Cilla
is an investment analyst with The Vanguard Group in London, UK
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Abstract

Some investment strategists advocate concentrated “best ideas” portfolios as the surest path to equity market outperformance. The premise is obvious: When a portfolio consists only of a manager’s best ideas, returns are undiluted by second-best or lesser ideas—but the reality is different. We used simulations and empirical analysis to evaluate the relationship between portfolio diversification and outperformance. We found that increasing concentration doesn’t raise the odds of outperformance; it lowers them. The less diversified a portfolio, the less likely it is to hold the small percentage of stocks that account for most of the market’s long-term return. Concentration can increase the odds of earning high margins of outperformance, but the probability of missing that return target increases more quickly than the probability of reaching it. Our analysis yielded two measures that a manager must meet to outperform the market: the “excess return hurdle” and the “success rate.” The excess return hurdle is the expected gap between portfolio and market returns at different levels of concentration; our analysis shows this decreases with increased holdings. Success rate is a measure of the manager’s ability to identify outperformers. The success rate necessary for a portfolio to outperform decreases as the number of holdings increases.

TOPICS: Portfolio theory, portfolio construction, statistical methods, simulations

Key Findings

  • • The expected gap between portfolio and market returns decreases with increased holdings.

  • • The “success rate” necessary for a portfolio to outperform decreases as the number of holdings increases.

  • • There is a highly significant positive relationship between the number of holdings and net excess returns.

  • © 2019 Pageant Media Ltd
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The Journal of Investing: 29 (1)
The Journal of Investing
Vol. 29, Issue 1
December 2019
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How to Increase the Odds of Owning the Few Stocks that Drive Returns
Chris Tidmore, Francis M. Kinniry, Giulio Renzi-Ricci, Edoardo Cilla
The Journal of Investing Nov 2019, 29 (1) 43-60; DOI: 10.3905/joi.2019.1.103

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How to Increase the Odds of Owning the Few Stocks that Drive Returns
Chris Tidmore, Francis M. Kinniry, Giulio Renzi-Ricci, Edoardo Cilla
The Journal of Investing Nov 2019, 29 (1) 43-60; DOI: 10.3905/joi.2019.1.103
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  • Article
    • Abstract
    • DISCERNING AN ACTIVE MANAGER’S BEST IDEAS IS NOT EASY
    • NOTES ON RISK
    • CONCENTRATION, RISK, AND RETURN: A BOTTOM-UP ANALYSIS
    • HISTORICAL INDIVIDUAL STOCK RETURNS
    • PORTFOLIO CONSTRUCTION SIMULATION
    • DATA AND METHODOLOGY
    • SIMULATION RESULTS
    • AVERAGE EXPECTED EXCESS RETURN: A PORTFOLIO’S EXCESS RETURN HURDLE
    • MORE CONCENTRATION, GREATER TRACKING ERROR
    • PROBABILITY OF ACHIEVING HIGHER EXCESS RETURN TARGETS
    • IMPROVING THE SUCCESS RATE
    • HISTORICAL APPROACH TO ANALYZING PORTFOLIO CONCENTRATION
    • DATA AND METHODOLOGY
    • SUMMARY STATISTICS AND RESULTS
    • IMPLICATIONS FOR INVESTORS AND FURTHER RESEARCH
    • CONCLUSION
    • ADDITIONAL READING
    • ACKNOWLEDGMENTS
    • Appendix I
    • Appendix II
    • Appendix III
    • ENDNOTES
    • REFERENCES
  • Info & Metrics
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