Terry Smith: Build a Concentrated Portfolio Or Buy The Index?

In his book Investing for Growth, Terry Smith discusses the general view that stocks outperform bonds, the reality is that most stocks do not, and the positive returns are largely concentrated in a select few.

Active investors typically fail to beat both equity indices and bonds, hindered by fees, inadequate skill, and biases leading to ineffective strategies. Successful active investing requires selecting a concentrated portfolio of high-performing stocks. However, for those unsure of their ability to identify these outliers, investing in an index may be the safer and more effective approach.

Here’s an excerpt from the book:

Most alarmingly, the median stock entering the market since 1977 did not just underperform Treasuries but had a negative return. This may be attributable to the type of companies which floated in recent decades, which many have characterised as showing revenue growth, but very poor earnings.

What conclusions to draw from all this? Stocks in aggregate outperform bonds, but most stocks do not and positive returns are concentrated in very few stocks. Most active investors are doomed to underperform not only the equity indices but also bonds.

This outcome has largely been attributed to the impact of fees, other costs, lack of skill and institutional biases producing closet indexation. But it may also be because their portfolios are more concentrated than the index but not in the few stocks which can produce outperformance.

Last and by no means least, of course, it shows that the returns from active stock selection can be large if the investor selects a concentrated portfolio of the few stocks which offer positive returns. But if you are not confident you can identify the few stocks which outperform not just the indices but also bonds, then just buy the index.

You can find a copy of the book here:

Terry Smith – Investing for Growth