Holding a diversified portfolio of mutual funds and exchange-traded funds (ETFs) has been shown to improve performance1, but there are also more intangible benefits.

Vanguard research has shown how investors who transition from concentrated investments in a few directly held shares to more broadly diversified portfolios can not only reduce the risks of investing in the stock market and increase their odds of outperformance—they can also derive more subjective benefits that might come as a surprise to some.

The shift from shares to funds

Up until the 1980s, most participation by US households in the stock market took the form of directly owned individual shares, most held within undiversified portfolios.

When Harry Markowitz published his seminal 1952 Portfolio Selection paper2, with its concept of the “optimal” portfolio balancing return and risk, this bore little resemblance to the way the bulk of investors were actually constructing their portfolios at the time.

In the early 1950s, around 4% of the US population invested in the stock market, and almost all of them owned their shares directly3. What’s more, there was little diversification. The median portfolio size was just two shares, while half of investors held just one. Less than half of one percent of investors held more than ten shares in their portfolios4.

In other words, 70 years ago, equity investing for most investors in many ways resembled a game of portfolio roulette. In today's terms, one spin of the wheel might come up Amazon. The next might be Enron.

But the 1980s marked a shift in the way US households invest, as the proliferation of diversified vehicles such as mutual funds and ETFs made portfolios with more balanced risk-return profiles accessible to ordinary investors. And as investors transitioned from individual shares to diversified funds, overall household assets in the stock market marched upwards, as the chart below shows.

Figure 1: Since the 1980s, household stock market exposure has shifted from stocks to funds

Notes: In Federal Reserve Board (2019), “mutual funds” includes all long-term mutual funds (stock, bond, and hybrid). ETFs are included in “corporate equity” holdings. To create the US stock fund and corporate equity categories for our analysis, we use data from the Investment Company Institute (ICI) to make adjustments to the Federal Reserve data. We remove bond and non-US stock funds from the mutual fund category (we make no adjustment for the small hybrid funds category). We also subtract the estimated household ownership of stock ETFs from corporate equities and add these values to the mutual fund category.

Sources: Vanguard calculations, based on data from the Federal Reserve Board and ICI.

In objective terms, this shift to more diversified funds has reduced the risk of stock market participation, producing improvements in portfolio performance, which is relatively easy to measure. For example, one study found that just 4% of publicly-traded shares have accounted for the US stock market’s entire net gain since 1926, a very concrete metric of the risk-reducing benefits of diversification5. And previous Vanguard research has shown that an investor’s odds of outperforming a relevant market benchmark increase as portfolio diversification rises6.

But the benefits don’t stop there. Beyond the improvements in portfolio performance, this broad diversification offered by funds and ETFs also has more intangible advantages for investors.

Measuring the investor welfare benefit

Our research quantified the investor welfare benefit—that is, the satisfaction that investors derive—stemming from the increased use of diversified investment vehicles.

To account for this return expectation and risk preference, we used a utility function—an economic concept that helps us measure the subjective values of different choices.

Similar research using utility functions has been conducted to quantify the value of services that, like diversification, have no explicit cost. For example, one study attempted to quantify the contribution of Facebook to consumer welfare, estimating that users value the social media network at $42.17 a month7.

Our findings show that the shift from individual shares to diversified funds in the US has produced hundreds of billions of dollars in investor welfare benefits since the 1980s. As the first chart below shows, we estimate the cumulative welfare benefit at $731 billion.

This estimate can be interpreted as what investors would need to have been paid to forsake diversified funds for the portfolios of one, two and three shares that predominated before the mid-1980s.

And, as the second chart shows, investors are paying less to access this benefit, which enhances its value. The cost of risk reduction has declined as price competition has driven fund expense ratios lower and investors have favoured these lower-cost funds.

Figure 2. The shift from stocks to stock funds has produced a cumulative investor welfare benefit of more than $700 billion

Notes: We multiply changes in the household mix of directly held stocks and mutual funds by the difference between the estimated utility scores of a three-stock portfolio and a diversified fund.

Sources: US Federal Reserve Board, Morningstar, ICI, Vanguard calculations.

Figure 3. The all-in cost of stock fund ownership is falling

Figure 3. The all-in cost of stock fund ownership is falling

Notes: All-in costs are the sum of US stock funds’ asset-weighted expense ratio and a sales-weighted estimate of the sales charges, or loads, paid by investors. We amortize this sales charge over ten years.

Sources: Morningstar, Arthur Wiesenberger & Company, ICI, Vanguard calculations.

In the US, investors are becoming more cost conscious for a number of reasons. For example, financial advisers have started to move from transaction-based to fee-based models, in which compensation depends more on their success in helping clients increase the value of their portfolios. Low-cost ETFs are increasingly being used to build these portfolios.

Looking to Europe

Our findings in the US could also have implications for Europe, where investors are also becoming increasingly cost conscious.

Lower-cost options are gaining traction with European investors as new regulations with a greater emphasis on fees take hold. Investors in Europe are also getting a better understanding of the impact that high costs can have on investment returns as online cost and performance comparison tools become more widespread.

The emergence of ETFs is raising awareness of costs, too. As an investment vehicle that mainly focuses on indexed strategies, ETFs have allowed investors to gain simple, low-cost access to a range of markets.

Read the Vanguard research paper.


1 Source: Tidmore, Chris, Francis M. Kinniry Jr., Giulio Renzi-Ricci, and Edoardo Cilla, 2019. How to Increase the Odds of Owning the Few Stocks That Drive Returns. Valley Forge, Pa.: The Vanguard Group.

2 Source: Markowitz, Harry, 1952. Portfolio Selection. The Journal of Finance 7(1): 77–91.

3 Source: Federal Reserve Board, 2019.

4 Source: Kimmel, 1952.

5 Source: Bessembinder, Hendrik (Hank), Do Stocks Outperform Treasury Bills?, 2018. Journal of Financial Economics 129(3): 440–457; available at https://ssrn.com/abstract=2900447 or http://dx.doi.org/10.2139/ssrn.2900447.

6 Source: Tidmore, Chris, Francis M. Kinniry Jr., Giulio Renzi-Ricci, and Edoardo Cilla, 2019. How to Increase the Odds of Owning the Few Stocks That Drive Returns. Valley Forge, Pa.: The Vanguard Group.

7 Source: Brynjolfsson, Erik, Avinash Collis, W. Erwin Diewert, Felix Eggers, and Kevin J. Fox, 2019. GDP-B: Accounting for the Value of New and Free Goods in the Digital Economy. Working Paper 25695. Boston, Mass.: National Bureau of Economic Research.

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