Why Not 100% Stocks? (Portfolio Concentration vs. Diversifying)

A popular paper in quantitative finance – for a period the #1 most downloaded paper on SSRN – is making the old argument for a 100% equities allocation.

The argument against the notion of a 100% equity allocation for long-term investors, based on recent discussions and longstanding financial principles is articulated below.

Key Takeaways – Why Not 100% Stocks?

• Risk Management
  • Diversification across asset classes, including bonds and alternatives, reduces portfolio volatility and safeguards against market downturns, essential for preserving capital in adverse conditions.
• Economic Misconceptions
  • Mass shifts towards equities inflate prices, lowering future returns.
  • Not everyone can outperform simultaneously.
• Practical Application of Leverage
  • Properly leveraging a diversified portfolio can achieve targeted returns with managed risk levels, which offers a balanced approach without overexposing to equity market fluctuations.

Fundamental Misinterpretation of Expected Returns

The idea that equities, due to their higher expected returns, should dominate a long-term investor’s portfolio overlooks basic financial theory.

While equities may indeed offer higher expected returns over time (as assets are available to us at face value), this doesn’t inherently justify a 100% equity allocation due to risk considerations.

Overemphasis on Historical Performance

Focusing solely on equities based on their past performance during periods of rising valuations, particularly in the US market, risks overestimating their future returns.

Such an approach neglects the potential for valuation adjustments and the cyclical nature of market returns.

Conflation of Risk and Return

Your main two considerations (“moments“) in a portfolio are:

• return
• risk

Most traders/investors, especially early in their journey, focus heavily on the first and not much on the second.

Advocating for an all-equity portfolio doesn’t adequately separate the concepts of maximizing returns from managing risk, or considering the ratio involved.

A diversified portfolio, before levering/delevering considerations, isn’t preferred for its higher expected return over stocks but for its superior risk-adjusted returns.

This distinction is critical in portfolio construction, where the goal is to optimize return for a given level of risk.

Portfolios are commonly engineered toward the desired level of risk, and not just stuffed with the highest-return asset class at the expense of all else because it gets the highest return as things come prepackaged.

Leveraging or de-leveraging the portfolio can adjust for desired return levels or risk tolerance.

Moreover, beyond mean (return) and variance (risk) considerations, there are other aspects to consider, such as skewness and kurtosis, which diversification also tends to improve – i.e., lower tail risk, better skew, shorter underwater periods, among other benefits (which we’ll cover more below).

Economic Misconceptions

The paper’s claim that adopting an all-equity strategy could result in trillions of dollars in welfare gains for Americans is criticized as economically flawed.

Shifting more investors toward equities would only increase prices and reduce future expected returns, not create additional wealth out of thin air.

Wealth in society is ultimately generated by our productivity.

Underutilization of Liquid Alternatives

The reluctance to incorporate liquid alternatives into portfolios, due to their perceived risk or volatility, overlooks their potential for enhancing diversification and risk-adjusted performance.

This aversion to alternatives, especially those marked to market, can hinder the overall effectiveness of an investment strategy.

Improper Risk Leverage Stance

The paper’s stance against leveraging a diversified portfolio to meet return objectives, while simultaneously advocating for a 100% equity position, reveals a misunderstanding of leverage’s role in investment strategy.

Properly applied leverage can adjust a portfolio’s risk profile to meet specific investment goals without resorting to a riskier, all-equity approach.

Example

As we’ve covered in other articles, diversification is fundamentally about improving return-to-risk.

For example, let’s say an all-stocks portfolio has 6% returns and 16% volatility.

And let’s say a diversified portfolio has 5% returns and 8% volatility.

The all-stocks allocation has a better return at face value, but it’s weaker on a risk-adjusted basis.

Such a portfolio can be levered to achieve 10% returns at the same volatility as the all-stocks portfolio, getting more return for the same risk.

(Also, if 8% vol is too much risk, cash can be held against it to de-lever.)

It also comes with a host of other benefits. For example:

• Left-tail risk will be lower
• Drawdowns will be shallower
• Underwater periods will be shorter (rather than lasting for many years, as they often do with equities)
• Upside-to-downside capture will be higher
• Your beta to the equity market will also be lower and your portfolio won’t be so dependent on positive economic circumstances to generate quality returns.

If traders/investors adopt a more nuanced perspective on leverage, moving beyond the semi-common binary view that “leverage is inherently risky and should be avoided at all costs,” they’ll see that a moderately leveraged, well-diversified portfolio actually poses much less risk than a portfolio that is not diversified and avoids leverage entirely.

Note that an all-stocks portfolio is inherently leveraged (companies have debt), which is why stocks outperform bonds over the long-run.

Necessity for a More Nuanced Analysis

A more useful analysis would consider a realistic estimate of the equity risk premium, address the feasibility of leveraging the best return-for-risk portfolio, and explore why some traders/investors might beneficially take on more risk.

Diversification remains a cornerstone of prudent trading and investment strategies, grounded in financial theory and practice.

A singular focus on equities, driven by their past performance and theoretical return potential, neglects the complex realities of risk management and portfolio construction.

Balancing a portfolio across different asset classes, including equities, bonds, and alternatives, offers a more sustainable approach to achieving long-term financial goals.