Welcome to Investing Insights. I’m your host, Ivanna Hampton. Some investors argue that putting much money into your best stock picks is the way to beat the market. Others claim that making an outsized bet on one or more stocks is too risky and akin to gambling. But what does the data say? How do substantial stock investments typically impact equity portfolios, positively or negatively? Jack Shannon, a Senior Manager Research Analyst at Morningstar, ran the numbers. He has arrived to impart the knowledge he has acquired. Check your 20Bet login for new market opportunities if you like strategic moves.
What is a ‘Big Bet’?
This study aimed to find cases from the past 25 years. It looked for instances where managers made significant investments. They don’t always call them “bets.” We used the SEC’s guidelines to show that a 5% position is significant. So, we searched for positions that averaged 5% of the portfolio over their lifetime. Yet, we decided to go further and set 8% as the least peak position size. Additionally, to qualify as a “bet,” the position needed to be 5% larger than its weight in the index. If Apple is 12% of the Russell 1000 Growth index, we’d consider a 17% position an actual “bet.”
Active Managers Increased Big Bets
In 1997, 3% of portfolio managers took a substantial risk in their portfolios. By 2023, that number had jumped to 14%, reflecting an increase of more than four times. Now, what drove that? The ones making waves were the gamma stocks, often referred to as the “Magnificent Seven.” Managers had to maintain ownership of over 5% in both the Russell 1000 Growth and the Russell 1000 to display confidence in its considerable growth. Then, many of them bumped over the 8% max size limit. And then we still wanted to see the active bets. Yes, the active component was still present, but it was the group of stocks that led to the increase. If you remove those stocks from the mix, the level of speculation is similar to what it was 25 years ago. It dipped from the Great Recession and rose back up, but removing those is a slight difference.
Did Big Bets Help or Hurt Portfolios?
Approximately 60% of the stock picks outperformed the benchmark, indicating their success. However, only a third of the funds managed to beat the benchmark. This created a problem: winning stocks but underperforming funds.
There are a few reasons for this. The biggest bets (8-12% of the portfolio) leave 88% in other stocks. They drive performance. Second, a stock often underperforms at its maximum position size. That’s when the manager has the most conviction. Over half of these big bets lose value. Most then underperform the benchmark. The stock has shown strong performance over the years. But, it tends to perform when it is a large part of the portfolio.
The 25-year History of the Best and Worst Bets
The surprising part was the performance after hitting the maximum position size. I would like to know if diversification is essential. Can some managers succeed with a more concentrated approach? Diversification is critical, and more than big bets are needed to drive performance. Yet, there are exceptions. Horizon Kinetics owns a substantial portion of Texas Pacific Land Corp. Baron Capital, which has done well with Tesla. A single position drives both. Is it feasible to count on these substantial wagers when advising on funds? Managers often struggle to find a company’s peak value. So, while some have profited from concentrated positions, they can backfire.
