You’ve probably heard that missing the best days in the stock market can hurt your portfolio’s long-term performance (but if you’re not familiar with that idea, please read this post). However, there’s a miss that can pound your portfolio even harder: failing to include the best-performing stocks in your portfolio.
The Missing Opportunity graph below shows that typically a few strong stocks account for much of the market’s annual gains. Over an extended period of time, failing to hold the best-performing stocks can cripple returns.
Many people react to these statistics by concluding that they should try to find the best stocks. That’s logical, but not practical. There is no evidence that investors can reliably accomplish that goal.
In fact, professional investors have a very poor stock picking record. Volumes of research have concluded that it is very difficult, if not impossible, to consistently pick the best-performing stocks. The recent results of professional stock pickers are shown below. More than half of actively managed mutual funds failed to beat their benchmark, with the exception of the international small cap category.
You may wonder, “Can’t I just invest in funds that have outperformed their index?” The next graph illustrates how that approach is unlikely to succeed. Why? Because good performance typically doesn’t persist over the long run. Only 8% of the top-performing funds of 2002-2006 remained in the top category over the subsequent five-year period. This pattern held across all investment categories. If investors in 2007 had selected the top-performing funds from the period, the results over the period 2007-2012 probably disappointed them.
The good news is that you don’t need to narrow your portfolio to the handful of best-performing stocks or funds to succeed. Instead you can use diversification to your advantage with this three-step approach:
- Establish your portfolio by investing in low-cost, broadly diversified asset-class funds.
- Rebalance your portfolio to keep your asset allocation on target.
- Re-evaluate your goals and financial circumstances at regular intervals, so you can adjust your asset allocation targets as necessary.
With this approach, you’re unlikely to get blindsided by not owning the best-performing stocks. Plus, you can avoid the expensive mistakes made by your peers and enjoy the long-term performance opportunity offered by the stock market.