death of diversification retirement researcherEveryone is always eager to declare the death of diversification. They say it fails in a crisis, that correlations are going up throughout the markets, or that building a diversified portfolio is just too dang time-consuming and expensive (seriously).

Now people are ringing the same death knell because so much of the market’s returns are coming from just a handful of companies. And they’re right – the market’s returns have been driven by a small group of companies this year.

Year to date, about one-third of the S&P 500 Index’s total return is from five companies, and nearly half of the return is from only fourteen. But just like Mark Twain, reports of diversification’s death are greatly exaggerated.

In fact, the fact that so much of the market’s return is from a minuscule number of companies is a powerful argument against the death of diversification.

If you don’t diversify because of top-heavy market returns, then you have to be able to predict which stocks will be in that top handful. If you could reliably predict which stocks to own, then you’d be crazy to buy anything besides winners. The problem is, it’s pretty much impossible.

I could rehash the normal arguments against active management (persistence studies, lack of observed risk-adjusted alpha, or just the simple arithmetic of active management), but this year has given us a nice example of active manager’s lack of prescience.

Since the beginning of the year, Apple has contributed the most to S&P 500 Index returns. That’s partially because Apple is massive – it’s the largest company in the world, representing 2 percent of the world’s total market value and about 4 percent of the S&P 500 Index. But they’re also having a good year. As of the end of last week, Apple was up almost 32 percent on the year.(1)

This is all well and good, but last week I wrote about how Apple is wildly underweighted by active managers. Apple represents about 2 percent of the global market value, but it only represents about 1.3 percent of the portfolios of global active fund managers. As a group, they’ve decided to underweight Apple by about one-third. It was the most underweighted stock by active managers in the world.

A lot of active managers have over-weighted Apple this year, but as a class, active managers have decided to take a hard pass on the stock that contributed the largest portion of the S&P 500’s returns.

This isn’t some no-name company or microcap security that no one has ever heard of that happened to quintuple – this is the largest, most obsessively followed company in the world.

If the collective wisdom of the world’s active managers couldn’t identify that the largest company in the world would be one of the market leaders this year – in fact, they bet pretty heavily that it would have a bad year – why would you think they can predict what other stocks will do?

Since market prices already include all publicly available information (which includes expectations of what will happen in the future), they move on what happens next. Prices move based on how the future compares to what our expectations of the future were.

So, unless you are better at predicting the future than everyone else, you just can’t reliably guess which stocks will go up or down – let alone which ones will drive the market’s returns.

So where does this leave us? Has the death of diversification really arrived? Not at all.

Since we can’t predict which stocks are the “right” ones to own, we need to buy them all. If you’re investing in the stock market, you want to capture the long-term expected returns the market offers.

But market returns are, to use a technical term, lumpy (I’m not being facetious here). If we’re trying to guess what the markets will do, we stand a really good chance of missing the good lumps.

And when they’re gone, they’re gone. We can’t get them back. Diversification – owning everything – means you won’t miss the good lumps and you can focus on harvesting the long-term returns that will help you reach the retirement you want.

(1) As of market close on Friday, May 26. Year-to-date return computed using data from Yahoo! Finance.

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