The expected return of a portfolio is the average of all possible future outcomes. Diversified portfolios provide the same expected return as concentrated ones, but with less risk. This suggests that investors who choose to diversify their portfolio don’t have to give anything up in return for the reduced risk. As a result, many experts label diversification as the only free lunch in investing. But while having the same expected return as concentrated portfolios, truly diversified portfolios do relinquish some upside potential. What is the upside and the downside potential of a concentrated portfolio? We look at the returns of the 238 stocks currently making up the S&P/TSX Composite Index to look for an answer.
Upside and downside in 2015
The year 2015 was a bad one for Canadian stocks, as the S&P/TSX Composite Index returned -8.3%. How far could a successful security selection have improved this result? And how much could be lost due to poor stock picks?
To pinpoint the upside and downside resulting from picking stocks among S&PTSX constituents, we computed the return on each stock. We then sorted them by return and grouped them into quintiles. The top quintile therefore includes the best-performing 20% among companies in the index, the second quintile has the second-best, and so on. The results are depicted in Table 1 below.
Table 1: S&P/TSX Composite Return Analysis (2015)
SECURITIES RANKING |
ONE-YEAR RETURN |
Quintile 1 |
+12% to +154% |
Quintile 2 |
-2% to +12% |
Quintile 3 |
-19% to -2% |
Quintile 4 |
-33% to -19% |
Quintile 5 |
-78% to -33% |
Source: Bloomberg
Overall, the stocks within the best-performing quintile returned between +12% and +154%. Despite the fact that the index overall produced a negative return in 2015, an investor who had picked stocks from this quintile would have obtained a return well into the double-digit territory. On the other hand, an investor who had picked stocks from the lowest quintile would have had a loss between 33% and 78%.
Upside and downside over five and ten years
While the quintile analysis over a one-year period is interesting, doing the same exercise over five and ten years produces spectacular results. In this section, we analyze the cumulative returns on all the current index constituents to better illustrate the potential gains and losses from concentration.
Table 2: S&P/TSX Composite Cumulative Return Analysis over five and ten years
|
CUMULATIVE RETURN |
SECURITIES RANKING |
5 YEARS |
10 YEARS |
Quintile 1 |
+110% to +2,700% |
+218% to +4,654% |
Quintile 2 |
+65% to +110% |
+107% to +218% |
Quintile 3 |
+19% to +65% |
+61% to +107% |
Quintile 4 |
-50% to +19% |
-26% to +61% |
Quintile 5 |
–93% to -50% |
-93% to -26% |
Source: Bloomberg
Under a positive scenario, a first-quintile portfolio could produce cumulative returns ranging between 110% and 2,700% over five years, and between 218% and 4,654% over ten years. Under a negative scenario, the losses could range between 50% and 93% over five years, and 26% to 93% over ten years.
Conclusion
Our analysis demonstrates that concentration provides investors with the opportunity for extreme gains. Over five to ten years, the value of a concentrated portfolio can multiply several times. However, this upside potential comes at the cost of risking deep losses, even after waiting several long years for a return on investment. We believe investors who choose a diversified portfolio make a conscious choice to favour risk management over extreme potential gains. On the other hand, concentrated portfolios are appropriate for speculators.