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

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

The 2025 Australian Federal election – implications for investors

With an election due by 17 May, we are effectively in campaign mode with the Government announcing numerous spending promises since January and the Coalition often matching them. Here's what the election means for investors.

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

Latest Updates

Investment strategies

4 ways to take advantage of the market turmoil

Every crisis throws up opportunities. Here are ideas to capitalise on this one, including ‘overbalancing’ your portfolio in stocks, buying heavily discounted LICs, and cherry picking bombed out sectors like oil and gas.

Shares

Why the ASX needs dual-class shares

The ASX is exploring the introduction of dual class share structures for listed companies. Opposition is building to the plan but the ASX should ignore the naysayers and bring Australia into line with its global peers.

The state of women's wealth in Australia

New research shows the average Australian woman has $428,000 in net wealth, 40% less than the average man. This takes a deep dive into what the gender wealth gap looks like across different life stages.

Investing

The two most dangerous words in investing

Market extremes are where the biggest investment risks and opportunities lie. While events like this are usually only obvious in hindsight, learning to watch out for these two words can alert you to them in real time.

Shares

Investing in the backbone of the digital age

Semiconductors are used to make microchips and are essential to a vast range of technology and devices. This looks at what’s driving demand for chips, how the industry is evolving, and favoured stocks to play the theme.

Gold

Why gold’s record highs in 2025 differ from prior peaks

Gold prices hit new recent highs, driven by a stronger euro, tariff concerns, and steady ETF buying – all while the precious metal’s fundamental backdrop remains solid amid a shifting global economic landscape.

Now might be the best time to switch out of bank hybrids

In this interview, Schroders' Helen Mason discusses investing in corporate and financial credit securities, market impacts of tariffs, opportunities for cash investments, and views on tier two and hybrid bonds.

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.