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How to increase the odds of owning the few stocks that drive returns

14 March 2019 | Topical insights

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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.

This Vanguard research paper uses simulations and empirical analysis to evaluate the relationship between portfolio diversification and outperformance. Rather than raise the outperformance odds, increasing concentration 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 yields 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, and 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.

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