Household stocks: The fewer, the better
ANN ARBOR, Mich.—Who says a diverse portfolio is better? When it comes to individual investing, stock trades made by households with fewer stocks outperform those with more diversified accounts, according to researchers at the University of Michigan and University of Illinois.
Moreover, the excess return of these concentrated portfolios is stronger for local stocks and for stocks not included in the S&P 500 Index.
"On average, the stocks bought by individual investors underperform the stocks they sell by a wide margin," said Clemens Sialm, assistant professor of finance at Michigan's Stephen M. Ross School of Business. "However, the reverse is true for wealthy households with concentrated investments.
"Specifically, trades of concentrated households perform significantly better than the trades of diversified households—even after controlling for households' average investment ability. The result is particularly strong for households with large account balances."
According to a new study by Sialm of Michigan and Zoran Ivkovic and Scott Weisbenner of Illinois, stock picks of concentrated investors (those holding one or two stocks) outperform those of diversified investors (those with three or more stocks) by about 1 percentage point over the year following a stock purchase.
For households with relatively large portfolios ($25,000 or more), the difference in returns for concentrated vs. diversified investors is 3 percentage points. For investors with portfolios of $100,000 or more, the difference is 4 percentage points. However, purchases made by concentrated households with portfolios less than $25,000 fare no better than purchases made by diversified households.
"Unlike households with small portfolios, wealthy households have the resources to hold a larger number of stocks, if desired, and thus obtain the potential benefits of diversification," Sialm said. "We find that wealthy investors with concentrated stock portfolios are significantly better stock pickers than their more diversified counterparts."
The researchers also found that the excess return associated with concentration is stronger for investments in stocks of local companies and in stocks not included in the S&P 500—which tend to have less analyst coverage and national media attention.
"This finding potentially reflects concentrated investors' ability to exploit information advantages," Sialm said. "Skilled investors can concentrate their portfolios in the stocks about which they have particularly favorable information."
In all, the link between performance and concentration does not mean that by simply altering one's portfolio to hold just a few stocks, performance will improve, the researchers say. Rather, it suggests that some investors with superior stock-picking ability exploit their skills by concentrating their portfolio in a few stocks.
For a copy of the study, see: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=568156
Contact: Bernie DeGroat