Distribution of stock returns

"Distribution of stock returns" is one most significant factor when it comes to stock market analysis and information. There have been tons of research works carried out to examine the fit of three different statistical distributions to returns of the S&P 500 Index from 1950 to 2005. While the normal distribution is a poor fit to daily percentage returns of the S&P 500, the lognormal distribution, on the other hand, is a poor fit to single period continuously compounded returns for the S&P 500, which implies that future prices are not lognormally distributed.

One very interesting point raised by a guy named Eddy Elfenbein on his Crossing Wall Street blog about the distribution of stock returns. The takeaway is that most individual stocks don’t do much. As a matter of fact the post said that only one in five stocks is a “significant winner.”

The argument being made was that too much diversification might have an adverse effect like what the economists call "Diminishing Returns". But this can to explained in a bit different way! There are many around the world who manage accounts that have 40-45 holdings when fully invested. Many of those, around 75%, are stocks, while the rest are ETFs. The discussion is all about the the equity portion of the portfolio.

Many people around me tend to build up portfolios from the top down going sector by sector. Prior to stocks being selected, people tend to make decisions regarding over weighting or under weighting of the sectors. Following this people decides on what countries to buy.

According to the "Top Down Theory", the stock selection is the least important part of the process the idea being that if you figure out, for example, that you want to own a Norwegian oil stock and get Norway right and get the sector right that the few stocks you would choose from will all correlate closely and to the actual stock chosen becomes a shade of gray.

The above piece has been extracted from the article "Is Diversification A Bad Thing?" written by Roger Nusbaum. Roger has talked about diversified topic on related to stock Market conditions... the worth mentioning of which is "How Broken Is The Financial Services Industry?"