Why diversification in investment pays off

Part of the recipe for successful investing is to buy ownership in many more companies and stay on the journey for many years.

In practice, however, only a few of the companies give very high returns and thus ensure that even with a number of bad stocks in the portfolio, you end up with a reasonable return overall. But how many companies actually perform well and poorly?

Venture investments - where the risks are highest

Investing in start-up companies - also known as venture capital - is considered to be the riskiest. There is a preponderance of companies that make losses for investors, while a small number of companies offer extremely high returns.

A few years ago, the investment firm Correlation Ventures looked at the numbers. A review of nearly 22,000 venture investments showed that 65% of them ended in losses. About ten percent of the companies returned more than five times, while 0.4 percent returned 50 times. The figures are shown in the graphic below

So if you invest in 20 smaller companies, it takes a good deal of talent - or luck - to make a reasonable return. With few venture investments over a lifetime, you are looking for the needle in the haystack that will provide the extraordinary return. The alternative is to buy the whole haystack and make sure you get the needle.

Distribution of returns from 21,640 US venture investments

...but, listed shares are actually quite similar to venture

However, the difference between the riskiest part of equity investing (venture) and the listed market is not that great. A study by J.P. Morgan for the period 1980-2014 of the broad Russell 3000 index of US stocks showed that 40 percent of stocks made losses for investors over their lifetime.

While this is a lower proportion than the 65% for venture companies, as the figure above shows, the returns on the many thousands of shares are also very different: As with venture investing, few companies deliver extremely high returns. Good examples of this are Apple and Amazon, which in 2017 accounted for seven and six percent of the S&P 500 index returns (source: Morgan Housel: The Psychology of Money). If we peel off another layer, it is individual products such as iPhones, Amazon Prime and Amazon Web Services that drive profits. A few companies and products can account for large parts of the returns.

Diversification pays off

Of course, a concentrated portfolio with more of the good companies can produce phenomenal returns. Conversely, missing the top ten percent of companies can also be an expensive pleasure. Diversification is relevant for both venture investments and listed equities and, of course, the investments in between - for example, private equity.

Napoleon is said to have defined a military genius as someone who can do the average thing when everyone else is acting crazy. In terms of investing, this is relevant because financial advice is often about which stocks are looking good today and whether prices are going up or down. Instead, we should think and act long-term and keep a cool head to ensure our prosperity.

With Assure's merger with Assure Fondsmæglerselskab, the group can now offer a wide range of investment advice. We create long-term investment plans based on facts and help you execute them.

Feel free to contact us.