Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 203

Diversification captures the winning outliers

At a conceptual level, diversification is about spreading risk and not putting all our eggs in one basket. Quantitatively, as I’ve previously explained, one of the main benefits of diversification is lowering the volatility for a given level of expected return. Another way of looking at it is that diversification allows an improvement in returns for a given level of risk, either through levering up to our desired risk tolerance or by capturing positive outliers in the return distribution of stocks in the market.

A few stocks can drive the overall index

Both here and abroad, a concentration of stock returns has often driven overall market performance, in that a relatively small number of large-cap ‘winners’ can carry an entire index. One key implication is there is potentially a large opportunity cost of not holding the index or a broad market portfolio, particularly in a bull market, either through attempts at stock picking or trying to diversify using only a few stocks. By constructing a narrow portfolio using a limited number of securities, significant returns might be left on the table.

Much has been written about the underperformance of most active managers against their respective benchmarks, and one possible reason is the degree of outperformance by a relatively small number of stocks. These positive outliers may not have been held or have been held underweight by underperforming active managers, dragging down overall fund returns relative to the index.

To investigate the degree that a small number of stocks drive index performance, let’s decompose the returns in the S&P/ASX200 Total Return Index over the past few years and find out which stocks were the key drivers of index performance during broad market rallies.

S&P/ASX200 Total Return Attribution

Source: Bloomberg. Total returns include reinvested dividends. Past performance is not an indication of future performance.

The table shows that in most return periods in recent years, a few large cap stocks have driven the S&P/ASX 200’s returns. For example, just 4 stocks – CBA, WBC, CSL and TLS – accounted for 51% of the index’s 55.29% total return (4.5% annualised) over the past 10 years, with the average return of just those stocks 256% over the period (13.5% annualised).

Active managers need to pick these winners

There are a number of ways of interpreting the results. One is that large index-beating return possibilities have existed by picking the right stocks in recent years. However, the risk of underperformance and likelihood of failing to include the right stocks are also large because the number of index drivers have been so few.

It would be remiss not to point out that the reverse could well happen during a bear market, where a handful of large-caps could drive the overall index lower. For example, BHP was a particularly large driver of 2011’s market correction and weighed heavily on S&P/ASX200 returns in 2014 and 2015. But assuming we’re taking a long-term view, the market tends to trend upwards over time.

Caution is also needed regarding the nature of market cap weighting, as past ‘winners’ will account for an increasingly larger index share over time, which we’ve seen for the major banks. This may increase the likelihood that yesterday’s heroes could become tomorrow’s broad market villains in a correction, due to the nature of their outsized weightings. Using an alternative weighting strategy to market cap (such as Research Affiliates’ fundamental weighting methodology) can potentially reduce this risk.

If you have a particularly strong view and have confidence in the stock picking abilities of yourself or a fund manager, you should back yourself. However, it’s worth keeping in mind that failure to pick the few stocks that drive an index’s returns could generate significant underperformance.

 

Chamath De Silva is an Assistant Portfolio Manager at BetaShares Capital. BetaShares is a sponsor of Cuffelinks and issues broad market ETFs such as AUST, QOZ, GEAR or WRLD. This article is general information and does not consider the circumstances of any investor.

RELATED ARTICLES

Changing times as share investors settle in for the long haul

Worried about low rates, SMSFs drop banks and diversify

Headwinds and tailwinds, a decade in review

banner

Most viewed in recent weeks

Finding the best income-yielding assets

With fixed term deposit rates declining and bank hybrids being phased out, what are the best options for investors seeking income? This goes through the choices, and the opportunities and risks involved.

What history reveals about market corrections and crashes

The S&P 500's recent correction raises concerns about a bear market. History shows corrections are driven by high rates, unemployment, or global shocks, and that there's reason for optimism for nervous investors today. 

Howard Marks: the investing game has changed

The famed investor says the rapid switch from globalisation to trade wars is the biggest upheaval in the investing environment since World War Two. And a new world requires a different investment approach.

Welcome to Firstlinks Edition 605 with weekend update

Trump's tariffs and China's retaliatory strike have sent the Nasdaq into a bear market with the S&P 500 not far behind. What are the implications for the economy and markets, and what should investors do now? 

  • 3 April 2025

Designing a life, with money to spare

Are you living your life by default or by design? It strikes me that many people are doing the former and living according to others’ expectations of them, leading to poor choices including with their finances.

World's largest asset manager wants to revolutionise your portfolio

Larry Fink is one of the smartest people in the finance industry. In his latest shareholder letter, the Blackrock CEO outlines his quest to become the biggest player in private assets and upend investor portfolios.

Latest Updates

Investment strategies

An enlightened dividend path

While many chase high yields, true investment power lies in companies that steadily grow dividends. This strategy, rooted in patience and discipline, quietly compounds wealth and anchors investors through market turbulence.

Investment strategies

Don't let Trump derail your wealth creation plans

If you want to build wealth over the long-term, trying to guess the stock market's next move is generally a bad idea. In a month where this might be more tempting than ever, here is what you should focus on instead.

Economics

Pros and cons of Labor's home batteries scheme

Labor has announced a $2.3 billion Cheaper Home Batteries Program, aimed at slashing the cost of home batteries. The goal is to turbocharge battery uptake, though practical difficulties may prevent that happening.

Investment strategies

Will China's EV boom end in tears?

China's EV dominance is reshaping global auto markets - but with soaring tariffs, overcapacity, and rising scrutiny, the industry’s meteoric rise may face a turbulent road ahead. Can China maintain its lead - or will it stall?

Investment strategies

REITs: a haven in a Trumpian world?

Equity markets have been lashed by Trump's tariff policies, yet REITs have outperformed. Not only are they largely unaffected by tariffs, but they offer a unique combination of growth, sound fundamentals, and value.

Shares

Why Europe is back on the global investor map

European equities are surging ahead of the U.S this year, driven by strong earnings, undervaluation, and fiscal stimulus. With quality founder-led firms and a strengthening Euro, Europe may be the next global investment hotspot.

Chalmers' disingenuous budget claims

The Treasurer often touts a $207 billion improvement in Australia's financial position. A deeper look at the numbers reveals something less impressive, caused far more by commodity price surprises than policy.

Fixed interest

Duration: Friend or foe in a defensive allocation?

Duration is back. After years in the doghouse, shifting markets and higher yields are restoring its role as a reliable diversifier and income source - offering defensive strength in today’s uncertain environment.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.