Learning the Wrong Lessons

A recent study by Professor Hendrik Bessembinder found that over very long periods of time, most individual stocks underperform the benchmark, while a minority of stocks are responsible for the bulk of equity market gains.  While the results of this study have been lauded as revelatory in the financial media, they really should not be; after all, most new enterprises fail, so it should not be all too surprising that most small companies (which constitute by far the majority of underperforming stocks) should fail, too.

Even so, the Bessembinder study has been cited by “index investing” advocates who use it as ammunition to support their claims that stock picking is a futile endeavor, and that the only logical conclusion an investor can take away from the study is to invest passively in market capitalization-weighted index funds.  For example, in a couple of articles at ETF.com, Larry Swedroe cites the study (as well as a similar one by Longboard Asset Management) as evidence that index investors maintain a natural advantage due to an index fund’s weighting by market capitalization, because:

“[C]ompanies with rising stock prices carry larger weightings in the index.  Likewise, unsuccessful companies with declining stock prices receive smaller weightings.  Companies showing continued declines are eventually delisted to make way for growing companies.”

With all due respect to Mr. Swedroe, this is learning the wrong lesson.  As I have written before, oftentimes weighting by market capitalization is a disadvantage for investors, as good companies temporarily down on their luck are underweighted in the index if not excluded from it altogether, all in order to make room for newer, larger companies that many times are overvalued.  Such was the case in the late 1990s, when technology companies crowded out value-type companies, with subsequent index returns being very poor as a result.

Furthermore, as Professor Bessembinder notes himself, portfolios of small companies in general, and equal-weighted portfolios in particular, have generated higher returns than portfolios weighted by market capitalization, due to the advantages of tilts to small- and value-type companies, which are the results of rebalancing.  Indeed, Professor Bessembinder’s results show that while individual stocks in the largest decile of market capitalization (group 10) generated positive results 80% of the time, most individual companies in the lowest decile (group 1) failed to match the return on cash, but, as a group, generated higher “lottery-like” returns, which demonstrates both the small company premium, as well as the need for diversification among a portfolio’s small company bets:


This is confirmed by the data provided by Professor Ken French, whose data library provides portfolios encompassing the top 30% of stock market capitalization (the “High 30” portfolio), and the lowest 30% (the “Low 30”).  The small stocks represented by the Low 30 portfolio (capitalization-weighted) generated annualized returns of 11.9% versus 9.8% for the High 30 portfolio (again, capitalization-weighted).  The returns of both portfolios were enhanced by equal-weighting, with the equal-weighted High 30 earning 10.4% annually, while the equal-weighted Low 30 earned an astounding 14.8%:


Therefore, the real takeaway from Professor Bessembinder’s study is not that everyone should passively own the market, but that they should diversify prudently.  As Professsor Bessembinder writes:

“For those who are inclined to focus on the mean and variance of portfolio returns, the results presented here reinforce the importance of portfolio diversification.  Not only does diversification reduce the variance of portfolio returns, but non-diversified stock portfolios are subject to the risk that they will fail to include the relatively few stocks that, ex post, generate large cumulative returns.”

Given the importance of balancing risk and reward, it is not difficult today to build a portfolio that not only is sufficiently diversified, but also constructed in such a way that maximum possible returns can be captured in a tax-efficient manner.  This is likely the surest way to achieve superior long-term returns.

For further reading on the small company premium, see Clifford Asness of AQR here:


For further reading on portfolio size and diversification, see Wesley Gray, Ph. D. of Alpha Architect, here: