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April 21, 2009

Diversification and Survivor Bias

ATT00261Most financial advisors agree on the need for investors to diversify their portfolio.  Diversification lowers risk.  The risk of buying one stock is over six times greater than the risk of buying a diversified pool of stocks.

Just look at what would have happened to someone who bought AIG one year ago.  Back then, it was trading at near $50 per share.  Today, it is under $1.50 per share.

Suppose you want to buy stock in companies that make up the S&P 500.  With each purchase of stock from an additional company, your portfolio’s risk characteristics would decline until you owned enough stocks in enough companies to be equal to the risk level of the S&P 500.  Once you have built that portfolio, buying more stocks from companies comprising of the S&P 500 would not reduce your risk any further.  Studies show that the number of companies required to reach the S&P 500 level of risk is one hundred.

The S&P 500 is a value weighted index of 500 large companies.  Value weighted means that the S&P 500 averages are calculated by the total market value of the outstanding shares of each company.  To put it another way, the largest companies count more than the smaller ones.  So, the S&P 500 is not an average of the prices of 500 component companies, but is a weighted average where the largest companies have a big effect on the daily averages, and the smaller companies have a lesser impact.  The S&P 500 represents roughly 74% of the total market capitalization of the U.S. stock market, but not 74% of the publicly-traded companies.  It is considered the best indicator of large companies.

Of course, the S&P 500 is but one of a number of stock indices.  The Dow Jones Industrial Average is the best known.  The Dow is the weighted average of the nation’s 30 largest companies.  It was created back in 1886, and consisted of only 12 companies’ stocks (only one still remains in the index today).  The Dow represents 25% of the entire capitalization of the U.S.stock market.

There are indices for mid and small capitalization stocks.  The S&P 400 MidCap and the Russell 2000, respectively, are the two most common.  There are also indices for international, regional and individual countries. There are indices for almost every industry.  The list goes on and on.

Survivor bias is another problem with purchasing individual stocks as compared to owning a diversified pool of stocks from particular indices. Many investors look to historical rates of return for the Dow or the S&P 500, going back 10, 20, 30 or more years as a guideline to what might happen in the future.  Yes, these numbers can be computed with perfect 20/20 hindsight, but they understate the risk of buying individual securities from one such index.  The problem is the Dow and the S&P 500 of today is not the same Dow and S&P 500 of yesteryear.  The companies that make up these indices change.  There is a survivor bias.  Companies with poor performance are removed, while new companies are inserted.  Companies like Microsoft and Amazon were not a part of any indices in the 1960’s.  They did not exist. Many of the companies that were a part of the Dow or the S&P 500 back then have been acquired, merged or failed.  AIG was one of the Dow’s 30 just a year ago, but has since been dropped.  In the year 2007, 43 changes were made to the S&P 500, and that was not an extraordinary year.  The effect of this is that the true risk of owning an individual stock is even greater. The indices have a survivor bias.

The take away is that buying individual securities is very risky.  It makes more sense to own diversified pools of stock from a number of different indices or asset categories, including bonds, money markets, etc.  This diversification, within and across different asset classes, is referred to as asset allocation.

Building a portfolio that is right for you is not easy work.  Even when you do everything right, there are times when things will still go wrong.  It is the nature of the beast.  Markets go up over the long term, but as we have seen, can be very negative in the short run.  The key is understanding… market movements… how long your investment horizon is…how many years you have for your portfolio to appreciate in value… when will you need that portfolio to produce income for you, and for how long?  Then combine that
knowledge with your risk temperament to come up with a proper asset allocation strategy for you.

Your Money Concepts’ financial advisor is happy to work with you on your portfolio development and management.  He or she can help you get a better understanding of market movements, determine your investment horizon, and build your portfolio.  Most importantly, he or she will be there for you during both good and bad times.