Date
8 December 2016
If you have no idea how to identify winners, investing in a well diversified index fund and keeping it for a long period could be the best chance of getting great returns. Photo: Reuters
If you have no idea how to identify winners, investing in a well diversified index fund and keeping it for a long period could be the best chance of getting great returns. Photo: Reuters

Stock investing: To diversify or not to diversify

A couple of months ago, I read a story on the Motley Fool website about a report from Horizon Research on how a group of art brokers made a fortune in the 19th to the 20th centuries by investing in works of then emerging painters.

The report found that these agents were not particularly good at telling which artists would become famous. Their concept was to bet on a diverse group of painters with different styles.

The same approach also appears to work well in stock investing.

For instance, index funds have become very popular in recent years, taking away business from so-called active funds. One key reason is perhaps the difficulty of identifying winners from hundreds of thousands of companies.

A little known fact about the portfolio of index funds is that they are often full of investment failures, except that a few star performers are enough to chalk up huge gains to offset the losses and reward investors handsomely.

Take the Russell 3000 Index, for example, a widely diversified index which captures big, mid and small caps at the same time.

Between 1980 and 2014, as many as 40 percent of its constituent shares fell more than 70 percent and never quite recovered.

But guess what? The index climbed 49 times over the 35-year period.

Breaking down the change, 64 percent of Russell 3000 components underperformed the index, less than 30 percent matched or slightly outperformed, only 7 percent turned out to be big winners.

This example shows if you to invest in an index that is diversified enough and keep it for for a long period, the overall return can be stunning.

The full article appeared in the Hong Kong Economic Journal in Chinese on Sept. 21

Translation by Raymond Tsoi

[Chinese version 中文版]

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RT/RA

Columnist at the Hong Kong Economic Journal

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