Diversification with Individual Stocks

Over the last several years, I’ve read numerous articles suggesting that instead of using mutual funds, an investor can create a diversified portfolio by investing in 50 (or so) individual stocks.

At first glance, it seems to make sense. You’d be able to hold a few stocks from each of the major sectors. So it would seem reasonable to conclude that your return would (roughly) match the market return.

There’s one big problem though.

You might expect that the returns of individual stocks over a given period (if plotted on a chart) to look something like a bell curve:

• Centered around the average market return,
• Most stocks outperforming or underperforming by a couple percent, with a roughly equal amounts of stocks on either side, and
• A small amount of outliers at either end.

But that’s not how it works.

In reality, over any period, there will be a handful of stocks that severely outperform the market and make up a disproportionate amount of the total return.

In contrast–to look at the other end of the performance chart–we know that there is a limit to how severely any stock can underperform the market. (No stock can go below zero, of course.)

In other words, we know that the severe outperformers are outperforming by a greater degree than the degree to which the most severe underperformers are underperforming. (Yikes, it’s a tongue twister almost!) From this, we can conclude that more than 50% of stocks must be performing at a “below average” rate of return in order to balance out those mega overachievers.

For instance, over the last 13 years, the market (as measured by the S&P 500) is up a total of 249%. Microsoft’s stock, on the other hand, is up a total of 18,332%. Clearly, in order to balance out Microsoft’s astonishing performance, there must have been a multitude of stocks that performed below average.

In short, over any given period, most stocks must be underperformers. The way I see it, this leads to two conclusions:

1. Picking stocks is truly a gamble. There’s a possibility of a big payout, but the probability of any given stock even matching the performance of the market is less than 50%.
2. A portfolio of just 50 stocks is similarly risky.

It looks to me like massive diversification is the only reliable way to make sure these overachievers are in your portfolio. Does that make sense? Or is there something I’m missing here?