Betting Big on Stocks Rarely Beats Boring Investing

Jack Shannon, a senior manager research analyst for Morningstar Research Services, explains why some active fund managers’ bets on their highest conviction stock picks paid off, but their portfolio performance may not have shown it.

What is a “Big Bet”?

Active Managers Are Increasing Their Big Bets

Did Big Bets Help or Hurt Portfolios?

Wagering and the Magnificent Seven

Can Market Concentration Explain Big Bets?

Best and Worst Bets Over the Last 25 Years

Did Winning Stock Pickers Beat The Benchmark Again?

Key Takeaway for Investors

Read about topics from this episode.

The Best and Worst Mutual Fund Bets of the Past 25 Years

How Have the Magnificent Seven’s Earnings Been Looking?

Here’s Why Active ETFs Are So Hot Right Now

Large-Growth Active Fund Managers Have Faced an Uphill Battle

10% Stock Weights Are No Longer Shocking for Funds. Should They Be?

What to watch from Morningstar.

Charlie Munger, Warren Buffett Built Berkshire Hathaway to Thrive After They’re Gone

Why are Active ETFs Everywhere, and Are Investors Abandoning Mutual Funds?

Timing the Market Doesn’t Work — We Did the Math

Make the Most of Your HSA Benefits and Investments in 2024

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Ivanna Hampton

Jack Shannon

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Ivanna Hampton: Some investors argue putting a lot of money in your highest conviction stock picks is the way to beat the market. Others claim making an outsized bet on one or more stocks is too risky and similar to gambling. What does the data say? Do big stock bets tend to hurt or help equity portfolios? Morningstar Research Services senior manager research analyst Jack Shannon ran the numbers. He’s here to share what he learned.

Thanks for joining me, Jack.

Jack Shannon: Yeah, thank you for having me.

Hampton: So, Jack, you researched what kind of value so-called big bets bring to mutual funds. Let’s start off with how you define a big bet.

Shannon: Yeah. So, for this study, we wanted to find instances going back 25 years of managers who made sizable bets. Now they won’t tell you it’s a bet because they don’t always think in the sort of binary outcomes. So, for me, I was like, okay, what’s the starting point? For a diversified mutual fund, the 1940 Act says you can’t have more than 25% of your portfolio in positions that are 5% or more. So, by the SEC’s definition, 5% is sort of the starting point. So, I used that as the base and said, okay, we’re going to try to find every position that averaged 5% of the portfolio over its lifetime. But I was like, okay, well, we need to do a little more. Let’s just not use that as the base. Let’s go a little higher. So, I was talking to people in the halls and on different ratings committees and all that, and we kind of – we said like 8% is where – on our team, we’re like, 8% is getting pretty high. So, 8% is then the minimum we needed to see as the max. So, 5% average, at least 8% at some point in time over the holding period. And then, finally again, it needs to be a bet. So, it’s like, well, you need to be taking an active stance against the market. So, we need to be a 5% active position, meaning it’s 5% more than what would be in the index. So, you think like the big stocks today, like Apple is like 12% of the Russell 1000 Growth. We would want to see 17% position to call it a bet.

Hampton: All right. But most active fund managers, they don’t make these big bets, right? But there’s been an increase. What’s going on there?

Shannon: Yeah. So, if you go back to 1997, you had 3% of portfolio managers had what I define as a big bet in their portfolio. Fast forward to 2023, you had 14% of managers doing it, so more than a 4x increase. Now what drove that? It was mostly, the gamma stocks or the Magnificent Seven, whatever you really want to call them. They became so big in the Russell 1000 Growth and the Russell 1000 that managers who wanted to express any sort of conviction in it sort of had to get above that 5% average weight and then you see a lot of them bump over that 8% threshold for the max size. And then we still wanted to see the active bets. So, the active piece was still there, but it’s that basket of stocks that drove the increase. If you take those stocks out of the pool, the level of bets is similar to what it was 25 years ago. It dipped coming out of the Great Recession and rose back up, but it’s not a huge difference once you remove those.

Hampton: So, most big bets paid off. The active managers, they picked their winning stocks. Well, did it help or hurt their portfolios?

Shannon: There’s a few ways to look at it. So, if you look over the holding period of the stocks, roughly 60% of the bets paid off. What that means is over the holding period, the stock beat the underlying benchmark. So, it was a winner. Over those same periods, though, the funds themselves, only 33%-ish – I feel like 37% – but only about a third beat the benchmark. So, there’s this conundrum of you’re betting on these winners, but yet you’re still underperforming. So, there’s a few reasons for that. One is that the bet size, so we had that 8% minimum max, if that makes sense, very few got above 12%, though. So, even at your biggest size, you’re 12%, you still have 88% of your portfolio in other stocks that’s going to drive the majority of the portfolio’s performance. So, that’s a piece of it.

And then, another piece is the point at which the bet is its biggest size. So, we looked at that also where, okay, once it’s the biggest percent of the portfolio, how does the stock then do? Because that’s the point where the manager is expressing his or her biggest conviction, like this is the winner. And if you start at that point and look forward, over half lose value on an absolute basis, and a vast majority end up underperforming the benchmark. So, there’s an issue of, yes, it outperformed over the holding period, but in the period where they commanded the most amount of assets, the bets did poorly.

Hampton: Well, what if they never made those bets? I mean, how would their portfolios fare then?

Shannon: It turns out it doesn’t really matter. So, on the side of the funds that underperformed their benchmarks, if you took the bets out of those funds, 98% of them still would have underperformed the benchmark. So, the bets were not the reason for the fund underperforming. It was just poor stock picking throughout the portfolio. That was the reason.

On the other side, if you look at the stocks that did outperform the benchmark, 75% would have outperformed the benchmark even without the bet. So those were funds where the managers were picking good stocks throughout the portfolio and didn’t even really need the big bet to get that sort of index-topping performance. So that was one of the key takeaways is that you need good stock picking throughout a portfolio, and you can’t really rely on one big bet to swing the outcome one way or another.

Hampton: And what kind of companies or businesses were they wagering on?

Shannon: Not surprisingly, we talked about the big Magnificent Seven. That’s the majority of the bets. So, what I was interested in seeing was, these professional money managers, are they betting on any sort of unique stories that maybe the average everyday investor doesn’t? And not really. So, you don’t see them betting on big turnaround stories. So, you think about the GameStop mania from a couple years ago. That’s all the retail investors, one trying to screw over hedge funds on the short squeeze. But there’s also this turnaround story of, well, we can build a business back up and then make these big gains. You don’t really see professional managers doing that. You don’t see them buying unprofitable companies and placing big wagers on them. You see them buying big, established, entrenched companies – Alphabet, Apple, Microsoft, those kinds – and those are the majority of the bets.

Hampton: Now you’ve mentioned the Magnificent Seven a couple of times. Can the market concentration in those companies explain any increase in the big bets?

Shannon: It certainly explains, I guess, the increasing likelihood of it, just because, again, when a stock is 10% of the index, most managers are going to hold at least 5% in there, just because they don’t want one stock to dictate their relative performance. So, they’re all going to hold it. Most of them are at least going to hold it for some sort of risk management purposes.

So, just from the sheer size alone, they’re going to check usually two of the boxes being the average position size and then the max position size. They hit both that 5% and 8% threshold. Then it’s just a question of, was it ever a big active bet? And for a lot of managers, you look back and it has been at times. Microsoft hasn’t always been 10% of the index. And at times, a manager might have had 8% in it when it was 3% of the benchmark and then you get that 5%. Because, again, we looked at the whole holding period, which for some managers can be 10, 12 years where they’re holding Microsoft. And at some point in time in that holding period, if they had it for 5%, then it counts. So, there are some definitional things going on underneath the hood. But definitely the concentration alone is a lot of the story.

Hampton: So, what surprised you about the best and the worst bets over the last 25 years?

Shannon: Well, the surprising thing to me was the performance after the maximum position size. I did this to just I guess sanity check some just basic heuristics we have in manager research and investing overall, which is like, diversification is great. And so, I came into this like, well, are there managers who don’t need a diversified approach and they can use it more concentrated, bigger position size style? And so, it confirmed on one hand that the diversification piece is important and that these bets alone aren’t swinging performance. But then, I guess on the individual stock surprises, you’ve got some fund companies that have huge stakes in random companies. You have Horizon Kinetics, which is run by a guy named Murray Stahl, but a bunch of their funds have huge, huge stakes in this company Texas Pacific Land Corp, which owns a bunch of land in Texas, and they lease oil and gas rights out to oil companies and all that. But those have done exceedingly well, and it’s all been driven by just these positions in just this one company.

So, you get these examples, Baron with Tesla is another example, where you do see just one position driving a huge outperformance. And then the question is, well, when we’re recommending funds to investors or to clients, is that something we really – you can count on going forward? I think that’s going back to the position side, the maximum position size where we get a little skeptical is that – clearly managers have a little struggle with seeing the peak valuation of a company. And so, the question is with those two, have we reached the peak valuation and you’re still sitting on these huge sizes in the portfolio? So, it’s interesting in that it has worked for a handful of them, but there’s always examples of those backfiring too.

Hampton: Now, what about the stock pickers that pulled it off and they beat their benchmarks? Did they strike gold the second time?

Shannon: Another interesting finding of the study was, I guess, the success of subsequent bets. So, whether or not they hit it big on the first one or lost big on the first one, we found that subsequent bets, your success starts to decline. So, not only does your probability of beating the benchmark, meaning your stock actually beating the benchmark, not your fund, that declines consistently with the number of bets you make. And on top of that, the probability – I shouldn’t say the probability – but the prevalence of big blow-ups increases. So, we define big blow-ups as losing 50% or more within the stock price.

So, what’s interesting there is there could be two different dynamics, one being the manager who hit it big, maybe gets overconfident and says, ah, look, I made all this money on this one big bet, I can do it again, and then maybe he does, maybe he doesn’t. But then, if you don’t, there’s always that classic casino dilemma of, well, I just lost 100 bucks at the blackjack table, I’ll just go get another 100 and put it on one hand and then see if I can make my money back. There seems to be some sort of – at least some element of throwing good money after bad and like, oh, I missed on the first one, but I’m going to try to get it back on another big bet. So, we don’t know exactly what the split is between those two, but there is at least some evidence of both of those things going on.

Hampton: Is there another example of we’re coming off, maybe it’s like gambling, is there another reason why someone may say, I can do it again? Is it ego? Is it…?

Shannon: It could be ego. Most portfolio managers get to where they are because they’ve been successful throughout their career. And it’s like a professional athlete. You have to have guts and you have to have a belief in yourself to be good at it because there are going to be moments where you don’t look good. And so, you have to be able to have the fortitude to stick through it and say, no, I’m right, and I am talented, and I can do this. So, I think there is a lot of that, I guess, you can call it ego of like, I know what I’m doing, I know this hasn’t paid off before, but I’m sure I can get it right this next time.

Hampton: All right. So, let’s wrap this up with some key takeaways for investors.

Shannon: I think the key takeaway – gambling, it’s attractive, right? Because it’s a shortcut. Why work for 20 years when I can go buy a lottery ticket and get the money now and I don’t have to work for it, right? And I think there is a strain of that when it comes to investing where if you talk to anybody on the street, a lot of them think there’s this shortcut that you can take. Oh, the insiders know, like these, there’s this cabal of insiders and finance who know all the secret stock tips. And if I only could get one of those tips, I’ll be able to cut it all on there and get my financial freedom. But I think this shows that even among professional money managers, good investing is often done through a very boring, just consistent approach where it’s little successes here and there build up. But you can’t count on trying to make one big bet to drive an outcome. It’s just not something that is easily repeatable or even leads to any sort of long-term success.

Hampton: All right. So, take the boring path.

Shannon: Yeah, that’s boring, but it’s successful.

Hampton: Well, thank you, Jack, for your time today.

Shannon: Thank you.

Hampton: That wraps up this week’s episode. Thanks for listening. If you enjoy hearing market trends and analyst insights on our podcast, feel free to leave a five-star review on Apple Podcasts. It will help others find us. Thanks to senior video producer, Jake VanKersen. I’m Ivanna Hampton, a senior multimedia editor at Morningstar. Take care.