The Secret to Earning Amazing Returns

Many investors count on owning a diversified portfolio to help them reduce their risk and improve their overall returns. But a recent study shows that while the risk-reduction aspects of diversification may hold some value, opting for a less diversified portfolio may actually get you the biggest rewards.

An academic paper by professors at Harvard and the London School of Economics takes a close look at portfolios from hundreds of investment managers. The conclusion the researchers draw is that the typical "best idea" from a manager typically outperforms the market by a significant margin, and a manager's top five ideas also do well compared to the overall market. Beyond that, though, the rest of a manager's portfolio shows no statistically significant outperformance.

The study's methodology
One difficult aspect of this kind of research is determining what constitutes a manager's "best" pick. To simplify the process, the study looks at how much money a given manager invests in each stock in the portfolio and then compares that weighting to the relative market-cap weight of the company. Whichever stock has the highest overweighting is considered the manager's top pick.

A number of results -- some surprising, some expected -- come from this analysis:

  • While you might expect hundreds of managers to share a lot of the same top picks, they don't -- over 70% of best-idea stocks were picked by just a single manager.
  • Smaller, less-liquid, less-followed stocks provide the bulk of outperformance.
  • Investment managers choose the bulk of their stocks not because they have a belief that they'll outperform but rather to satisfy other demands of the industry, including reduced volatility and risk aversion.

What it all boils down to is that it takes many factors other than strict performance to explain what's going on with a typical investment manager's results. Moreover, you might be better off ignoring the bulk of a manager's advice to focus instead on just a small number of stock picks -- even if it means taking on the higher risk of a concentrated portfolio.

What you can do
Of course, just because a pro's best ideas do better than the market doesn't mean that yours necessarily will. But the study does suggest a number of steps you can take to try to improve your own investing results. Here are just a couple:

1. Stay small.
You're not going to outperform with your best ideas if everyone already knows about them. While some may argue about whether the stock market is generally efficient, most would agree that the more widely followed a stock is, the more efficient its trading is.

With big stocks, finding unique information is just about impossible. Look at how many professional analysts spend huge amounts of their time tracking single stocks like these:

Stock

Market Cap

# of Analysts Making Current Year EPS Estimates

Microsoft (Nasdaq: MSFT  )

$171 billion

32

Research In Motion (Nasdaq: RIMM  )

$39 billion

38

Johnson & Johnson (NYSE: JNJ  )

$147 billion

17

Merck (NYSE: MRK  )

$54 billion

17

ExxonMobil (NYSE: XOM  )

$329 billion

16

Source: Yahoo! Finance. Market cap as of April 17.

Meanwhile, smaller stocks are much less followed both on and off Wall Street. Tiny companies like Insteel Industries (Nasdaq: IIIN  ) and Universal Insurance Holdings (AMEX: UVE  ) have at most a couple of analysts looking at their financials regularly. If you find something interesting with small stocks, you'll have a much larger edge than you can ever hope for with blue chips.

2. Have conviction.
The best managers actually see their top picks do well, but they typically aren't allowed to risk all their clients' money on them. If you spend the time and effort to research stocks, you can have the same experience -- but you can also cash in on those great ideas.

Warren Buffett once said to invest as though you could choose only 20 stocks over your lifetime. So, don't mimic fund managers with hundreds of holdings just for the sake of it. Take a stand you believe in, and you'll likely do better.

Diversification can make investing a lot easier. But it won't necessarily produce better returns. To maximize your profits, you have to believe in your best investing ideas. The payoff can be truly amazing.

For more on the best investments, read about:

For tips on the best small companies that are flying under Wall Street's radar, take a look at our Motley Fool Hidden Gems newsletter. A free 30-day trial will give you some great investment ideas.

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Fool contributor Dan Caplinger constantly strives for confidence in his investing. He doesn't own shares of the companies mentioned. Microsoft is a Motley Fool Inside Value selection. Johnson & Johnson is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy believes in you.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 20, 2009, at 1:52 PM, icuryy4me wrote:

    I have often wondered if the risk of a highly diversified portfolio for an individual investor might actually be greater in practice for due to the increased workload of tracking so many companies.

    If you have a team working on it then the risk is reduced.

    The corollary of this is that for an individual the risk is less and the reward greater if the number of stocks is kept to a manageable number.

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