How does diversification benefit my portfolio?

Our analysis showed that investing in a random single stock from that list had a large range of outcomes both good and bad. The stock with the highest return during this time period was NVIDIA, which appreciated to 73 times its original value. However, 16 of 381 stocks lost more than half of their original value. The average return of the 381 stocks during this 10-year period was 362%, which is close to the S&P 500 index’s total return for the same period. Among these 381 stocks, only 136 stocks (a 136/381 = 35.7% chance) beat the average return of 362%. 

Our lookback analysis below shows how investing in a portfolio with more than one stock provided additional downside protection due to diversification. We tested portfolios containing either 1, 5, 10, 20, or 50 stocks by randomly drawing from the 381 stock universe 10,000 times. For example, we randomly selected 5 stocks out of the 381 stocks above and formed an equal-weighted portfolio. We repeated the draw 10,000 times, forming 10,000 5-stock portfolios. We applied the same methodology for the portfolios containing 1, 10, 20, and 50 stocks. 

The table below summarizes the results for each type of portfolio. For example, the second row summarizes the return distribution of the 10,000 randomly drawn equal-weighted 5-stock portfolios. For each distribution, we look at the lowest, 25th percentile, median, 75th percentile, and highest portfolio return out of the 10,000 portfolios. The last column of the table shows the number of negative portfolio return cases out of the 10,000 portfolios.

 

Number of stocks	Lowest Return	25th- percentile	Median Return	75th- percentile	Highest Return	Number of draws with negative returns out of 10,000 draws
1	-100%	99%	266%	487%	7,216%	1,019
5	-30%	236%	322%	442%	2,252%	4
10	53%	268%	338%	422%	1,387%	0
20	112%	294%	345%	404%	923%	0
50	195%	318%	351%	393%	638%	0

Source: Wealthfront

 

As our example illustrates, with only 1 stock in the portfolio, roughly 1,000 out of 10,000 draws had negative returns, i.e. losses. By increasing the number of stocks to 5, our analysis demonstrates that diversification could have reduced the likelihood and magnitude of loss. In our 10,000 random draws of 5-stock portfolios, only 4 portfolios lost money and the lowest return is much higher than the lowest return for a 1 stock portfolio. When we increased the number of stocks to 10 or higher, there were almost no losses. In general, the median return rose as the number of stocks in the portfolio went up, which increased the chance of beating the market average. Of course, you do have to give up some extreme upside in exchange for the downside protection, as the highest return comes down when the number of stocks increases, making the return outcome range more concentrated. 

In summary, you can diversify a single-stock portfolio by investing in just a few more stocks. Based on our analysis of these stocks during this 10-year time period, going from 1 stock to 5 stocks reduced the chance of loss and provided more concentrated return outcomes.

 

Disclosure

Investors may experience different results from the hypothetical returns shown above. No representation is being made that any client account will or is likely to achieve performance returns or losses similar to those shown herein. Hypothetical expected returns are presented for illustrative purposes only. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in achieving the returns have been stated or fully considered. Changes in the assumptions may have a material impact on the hypothetical returns presented. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) changes in laws and regulations and (4) changes in the policies of governments and/or regulatory authorities.

The information contained in this communication is provided for general informational purposes only, and should not be construed as investment or tax advice. Nothing in this communication should be construed as a solicitation, offer, or recommendation, to buy or sell any security. Any links provided to other server sites are offered as a matter of convenience and are not intended to imply that Wealthfront Advisers or its affiliates endorses, sponsors, promotes and/or is affiliated with the owners of or participants in those sites, or endorses any information contained on those sites, unless expressly stated otherwise.

Investment management and advisory services–which are not FDIC insured–are provided by Wealthfront Advisers LLC (“Wealthfront Advisers”), an SEC-registered investment adviser, and financial planning tools are provided by Wealthfront Software LLC (“Wealthfront”). Brokerage products and services are offered by Wealthfront Brokerage LLC, member FINRA / SIPC. All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. Please see our Full Disclosure for important details.

Wealthfront Advisers, Wealthfront Brokerage and Wealthfront are wholly owned subsidiaries of Wealthfront Corporation.

© 2022 Wealthfront Corporation. All rights reserved.