Invest like the worst: Wealth-destroying portfolio concentration

If you need to lose money fast, portfolio concentration is for you. I previously lamented the fact that both Buffett and Keynes argued against diversification. Here, I present evidence that portfolio concentration is typically favored by individual investors who are the opposite of Buffett and Keynes, namely those who are:

• Poorer and less educated
• Overconfident
• Anti-skilled (they buy stocks that subsequently underperform)
• Unable to do basic math
• Low IQ

If this list does not describe you, then keep reading; you are my target audience.

Now, I acknowledge that facts about retail investors do not necessarily apply to fund managers, or to capital allocators who select fund managers. But it’s at least worth knowing the facts. Fund managers with concentrated portfolios are often lauded as having the “courage of their convictions.” It turns out, however, that courage is not in short supply; it is wisdom and skill that are scarce. As Barber and Odean (1999) put it, “Overconfidence provides the will to act. It gives us the courage of our misguided convictions.”

Individual investors on average

I start in this section by discussing individual investors as a group and then move on later to the characteristics of the worst investors.

Gambling, overconfidence, and anti-skill

I’ve previously discussed evidence that individual investors

• On average lose money (they have anti-skill)
• Trade stocks because gambling is fun
• Are overconfident about their ability to pick stocks

Overconfident gamblers like risky bets. Portfolio theory says there are three ways to increase the risk of an unlevered long-only portfolio:

• Buy lottery-like stocks: select individual stocks that have above-average risk.
• Buy similar stocks: select stocks that are correlated with each other.
• Concentrate: put more weight into a small number of names.

Individual investors do all three of these things, a cluster of behaviors called “underdiversification.” Underdiversified portfolios are more risky than the market.

In addition to underdiversification, individual investors exhibit other behavior reflecting overconfident gambling, such as high turnover and sometimes high leverage. These are all part of a wider pattern of wealth-destroying behavior.

Underdiversification

Historically, individual investors have held wildly concentrated portfolios. Here’s Beshears, Choi, Laibson, and Madrian (2018):

…Blume and Friend (1975) found that the median U.S. household that holds stocks directly held only two stocks, and data from subsequent decades do not show significantly greater diversification in directly held stock positions (Kelly, 1995; Barber and Odean, 2000).

Looking at more recent data, Barber, Huang, Odean, and Schwarz (2022) report that the average number of Robinhood holdings in May 2020 is just three stocks per investor.

Of course, the right way to measure diversification is to look at an individual’s entire wealth, including mutual funds and other assets. The widespread adoption of mutual funds has greatly reduced the scourge of underdiversification. However, underdiversification remains rampant in some countries and for some populations of U.S. investors.

Why do some investors underdiversify? I’ve previously discussed psychological sources such as the illusion of control and familiarity bias. Another cause is pure, old-fashioned ignorance. Here’s Beshears et al (2018):

The most direct evidence that under-diversification is not fully rational may come from financial literacy surveys (Lusardi and Mitchell, 2014). Hastings et al. (2013) report that only about half of adults in the U.S., Netherlands, Japan, Germany, Chile, and Mexico can correctly answer a question asking whether the statement, “Buying a single company stock usually provides a safer return than a stock mutual fund,” is true or false—around what would be expected from random guessing. In India and Indonesia, the proportion who give the correct answer is only about 30%. Defined contribution plan participants on average rate the stock of their own employer to be less risky than an equity mutual fund (Munnell and Sundén, 2002; Mitchell and Utkus, 2003).

What’s bad about underdiversification? It causes some investors to have huge losses, and by some calculations, it’s a major social problem. Goetzmann and Kumar (2008) find that most U.S. investors suffer because they hold concentrated portfolios. Florentsen, Nielsson, Raahauge, and Ragnvid (2019) examine Danish investors in 2012. The average number of holdings is just two stocks and the median holding is just one stock. The probability that a typical Danish investor underperforms the market is 74%.

Florentsen et al (2019) have administrative data on every Danish investor and they say:

Given that we know the equity portfolio of all investors in a country, we can calculate the total loss, in terms of foregone expected returns, due to underdiversification. We find that the loss amounts to 3.1 percentage points per year in our baseline calculations.

As of 2012, mutual funds were not widely held in Denmark, and thus individual investors were able to run wild with underdiversification. In contrast, Calvet, Campbell, and Sodini (2007) study Sweden in 2002. There, mutual funds were widespread, and consequently underdiversification was less of a problem.

I’ve previously mentioned that according to the data studied by Barber, Lee, Liu, and Odean (2009), individual investors have anti-skill and underperform the market by 3.8% a year. This anti-skill is a completely different source of self-harm than underdiversification.  The big picture is that individual investors have managed to find portfolios that are simultaneously low mean return and high volatility: the Platonic ideal of terrible portfolio construction.

Who underdiversifies the most?

Poorer and less educated investors

Looking at the U.S., Goetzmann and Kumar (2008) find:

older, wealthier, more experienced, and financially sophisticated investors and those who exhibit a stronger propensity to diversify in other settings hold relatively better diversified stock portfolios.

Looking at Denmark, Florentsen et al (2019) find that investors with low education, low income, and low wealth are more likely to underdiversify. Anderson (2013) looks at Swedish investors and finds that sophisticated investors (richer, college-educated individuals) own 61% of the wealth and experience 22% of the trading losses, while unsophisticated investors (poorer, less well educated) have 3% of the wealth but experience 27% of the trading losses, partly because they have more concentrated portfolios.

Overconfident investors

Broekma and Kramer (2021) study Dutch investors. They measure investor overconfidence by comparing self-assessed financial literacy vs. actual performance on a financial literacy test and report that:

We find that a lack of proper portfolio diversification is positively associated with overconfidence. Part of this relationship is mediated through the lower propensity of overconfident individuals to hire a professional financial adviser.

I’m sure you know many people who appear overconfident in their pronouncements about life (“often wrong, but never uncertain”). These individuals are likely to hold one or two stocks.

Investors with stock picking anti-skill

Retail investors on average have both anti-skill and high risk. But there’s an elite group of retail investors who have extra anti-skill and extra high risk, churning concentrated portfolios and burning through their wealth. These are the George Costanzas of finance.

Goetzmann and Kumar (2008) find that investors who hold more concentrated portfolios have both higher turnover and lower average returns. They say:

… within most investor groups, the alphas are higher for the better diversified investor category. When we consider all investors in the sample, the less diversified investors earn 2.40% lower annual, risk-adjusted return than the more diversified group. … Interpreting alpha as a measure of stock-picking ability, the performance comparisons indicate that better diversified investors have better stock-selection abilities.

Anderson (2007) finds, looking at Swedish investors during the internet bubble that:

the quintile of investors who are best diversified earn 36 basis points per month more than those who are least diversified. … Undiversified investors are overconfident in their own stock-picking ability, because they are shown to take higher risks and perform worse than the average.

Investors with low math ability

Gaudecker (2015) studies Dutch investors. He finds that underdiversification is concentrated in those who are bad at math:

the largest losses resulting from underdiversification are incurred by those who neither turn to external help with their investments nor have good skills in basic numerical operations and concepts.

He finds that math ability, but not financial knowledge, is most helpful in predicting which individuals will underdiversify.  A sample multiple choice numerical question was “Suppose you had 100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?” In contrast, the ability to answer a question like “True/false: Buying a company stock usually provides a safer return than a stock mutual fund,” while seemingly very relevant, was not a strong predictor of actual diversification behavior.

Low IQ investors

Grinblatt, Keloharju, and Linnainmaa (2011) study male Finnish investors. In their population, the median number of stocks held is two. The authors possess amazingly detailed and accurate measures of both IQ and stock ownership:

We study Finnish stock market participation at the end of 2000 as a function of IQ measured early in adult life…The IQ scores are comprehensive for Finnish males in a 20-year age range because they are obtained on induction into Finland’s mandatory military service. We have IQ data on all inductees entering service between 1982 and 2001, as well as stock registry and mutual fund ownership data that unambiguously assess inductees’ stock or mutual fund ownership later in life…

They find that high-IQ men are more likely to have more diversified portfolios, both from holding mutual funds and from holding a greater number of individual stocks:

Sharpe ratios increase with IQ … High-IQ investors’ superior Sharpe ratios thus arise mostly from lower portfolio volatility … cognitive skill increases the number of stocks held.

So, there you have it. Diversification is literally a smart strategy. Be smart. Diversify.

References

Anderson, Anders. "Trading and under-diversification." Review of Finance 17, no. 5 (2013): 1699-1741.

Anderson, Anders. "All guts, no glory: Trading and diversification among online investors." European Financial Management 13, no. 3 (2007): 448-471.

Barber, Brad M., and Terrance Odean. "The courage of misguided convictions." Financial Analysts Journal 55, no. 6 (1999): 41-55.

Barber, Brad M., and Terrance Odean. "The behavior of individual investors." In Handbook of the Economics of Finance, vol. 2, pp. 1533-1570. Elsevier, 2013.

Barber, B.M., Lee, Y.T., Liu, Y.J. and Odean, T., 2009. Just how much do individual investors lose by trading?. The Review of Financial Studies, 22(2), pp.609-632.

Barber, Brad M., Xing Huang, Terrance Odean, and Christopher Schwarz. "Attention‐induced trading and returns: Evidence from Robinhood users." The Journal of Finance 77, no. 6 (2022): 3141-3190.

Beshears, John, James J. Choi, David Laibson, and Brigitte C. Madrian. "Behavioral household finance." In Handbook of Behavioral Economics: Applications and Foundations 1, vol. 1, pp. 177-276. North-Holland, 2018.

Broekema, Stijn PM, and Marc M. Kramer. "Overconfidence, Financial Advice Seeking and Household Portfolio Under-Diversification." Journal of Risk and Financial Management 14, no. 11 (2021): 553.

Calvet, Laurent E., John Y. Campbell, and Paolo Sodini. "Down or out: Assessing the welfare costs of household investment mistakes." Journal of Political Economy 115, no. 5 (2007): 707-747.

Florentsen, Bjarne, Ulf Nielsson, Peter Raahauge, and Jesper Rangvid. "The aggregate cost of equity underdiversification." Financial Review 54, no. 4 (2019): 833-856.

Gaudecker, Hans‐Martin Von. "How does household portfolio diversification vary with financial literacy and financial advice?." The Journal of Finance 70, no. 2 (2015): 489-507.

Goetzmann, William N., and Alok Kumar. "Equity portfolio diversification." Review of Finance 12, no. 3 (2008): 433-463.

Grinblatt, Mark, Matti Keloharju, and Juhani Linnainmaa. "IQ and stock market participation." The Journal of Finance 66.6 (2011): 2121-2164.