Friday, July 31, 2009
Wednesday, July 29, 2009
by Robin Bowerman, Principal and Head of Retail, Vanguard Investments
Politicians and economists share a common ability to fearlessly predict the way forward where mere mortals see confusion and uncertainty…
So it was refreshing to read the essay by the Prime Minister, Kevin Rudd, at the weekend. Naturally there was a fair bit of political positioning within it but the overriding message was a good reality check.
The sharemarket has enjoyed a rally since mid-March – and the S&P/ASX 200 index has recovered all the ground lost since last November - but this week commentators were excited about a 10-day winning streak. Now the best run of days of consecutive gains since 2004 and the strong positive news on the investment return front that flows from that is more than welcome given what investors have had to endure in the past 18 months.
But it would be easy to get carried away and think the worst has been put behind us and that it is all upside from here. Which was what made the Prime Minister's rather sober commentary noteworthy...
Thursday, July 23, 2009
The post-mortem on the global financial crisis is raising the question in some minds about whether it is time to read the last rites for diversification — the principle that you reduce your investment risk by spreading it around.
Among the would-be mourners are critics who say the diversification principle failed spectacularly for investors just when they needed it the most — during the biggest market meltdown seen in generations.
After all, the idea behind diversification is that no two investments perform in exactly the same way at the same time. By mixing up the asset classes in your portfolio and diversifying within those asset classes, the idea is that you provide yourself with a cushion or shock absorber in the down times.
But then came the financial crisis of 2008 and suddenly there seemed to be no safety net. Just about every asset class — apart from government bonds and cash — got walloped. In the jargon of financial economists, those asset classes appeared to become much more "correlated".
But the appearance of rising correlations does not necessarily mean that diversification does not work. And you can prove that by considering what might have happened if investors had been less diversified than they could have been last year.
It's a point made by Dartmouth Tuck School of Business finance professor Ken French in a new video on the forum he co-hosts with Eugene Fama, a finance professor at the University of Chicago Booth School of Business.
"Diversification still works," French explains in the interview. "And they (investors) would have had even more uncertainty about the return on their portfolios if they had been poorly diversified."
French points out that diversification does not eliminate the volatility of theoverall market. What it does do is protect against the additional volatility arising from the characteristics of individual firms or asset classes.
"It's that extra volatility that you don't have to have if you diversify well."
On the question of rising correlations in highly volatile markets, French notes that the return on any asset comprises two components — the market return itself and the return attributable to the specifics of the individual asset.
During the extreme volatility of 2008, the market movement became proportionately much more influential so that it appeared that individual stocks and asset classes appeared to be much more lined up with each other.
"What matters when we think about diversification is the firm-specific pieces, not the market piece," French says. "And we know that in these volatile periods, the firm-specific pieces also get bigger. So while it may look like the benefits of diversification have gone down, they have actually gone up."
These differences in the firm-specific variation in returns are what financial economists call "cross-sectional dispersion". And it is well established that just as market volatility tends to spike after periods of negative performance, so do the cross-sectional dispersions.
This table below shows the performance of four Australian portfolios (cash, simple diversified, sub-asset class diversified and all equities) over three different periods - the peak months of the financial crisis (Nov 2007 to February 2009), the recent recovery (March 2009 to June 2009) and the past quarter century.
The simple diversified portfolio ("Diversified A") is just 70 per cent Australian equities, 25 per cent bonds and 5 per cent cash. The sub-asset class portfolio ("Diversified B") breaks up the Australian equity component into large, value and small components. Common indices are used.
You can see that even during the worst of the crisis, a diversified portfolio provided a better result (or at least a less bad result) than an all-stock portfolio. While cash was clearly the best result of the three in this period, look at contrast between the three portfolios in the subsequent, admittedly very short, recovery period. Note too, that the Diversified B portfolio has performed better in the rebound, reflecting the tendency of small and value stocks to do outperform around economic turning points.
However, the key message is in the longest time period here, covering early-1985 to mid-2009. This shows returns from the diversified portfolios were very similar to the all-stock portfolio, but with much lower volatility.
What this all means for investors is that the need for broad diversification both across and within asset classes becomes even more important at times of high volatility.
In the words of Mark Twain, reports of the death of diversification have been greatly exaggerated.
(Thanks to Rob Brown for compiling the data for this article)
Sources and Descriptions of Data:
UBS Warburg 90-Day Bank Bill Index: 100%
Diversified Portfolio A
S&P/ASX 500 Accumulation Index: 70%
UBS Warburg 90-Day Bank Bill Index: 5%
UBS Warburg Australia Composite Index All Maturities: 25%
Diversified Portfolio B (Sub Asset Class):
UBS Warburg 90-Day Bank Bill Index: 5%
MSCI Australia Value Index (net div.): 14%
UBS Warburg Australia Composite Index All Maturities: 25%
S&P/ASX 100 Accumulation Index: 35%
S&P/ASX Small Ordinaries Accumulation Index: 21%
S&P/ASX 500 Accumulation Index: 100%
(All returns in $A)
Tuesday, July 21, 2009
(Thanks to Paul Douglas Boyer for the basis for this little summary)
...it is possible to invest without fretting over the ups and downs of the market.
A passive or indexing approach to investing involves concentrating on the things that we can actually control—asset allocation, fees, transaction cost and efficiency with which strategies are implemented.
This approach certainly does not offer a quick-fix and it does not carry any of the seductive qualities of gambling or day-trading. It not offer the sizzle that the media likes and if you are looking to investing to provide an adrenaline rush then you should be looking elsewhere.
Like most things of value in life passive investing takes discipline and time to reap the rewards. The process is based on a solid academic foundation of empirical research and it is the most intelligent and prudent way to build wealth over the long run.
Your investments should not be a cause of stress in your life.
By understanding this approach you will recognize that it offers the most sensible investment solution.
Sunday, July 12, 2009
Thursday, July 02, 2009
One of the great myths of the investment world is that you can build a successful long-term strategy around a carefully chosen small number of stocks that are perceived as generating good earnings growth year after year.
Just why this myth refuses to die may be a testament to the power of hope over experience. But it's useful now and then to see the dire results of concentrated portfolios, even those chosen by supposed experts.
In mid-2007, the Australian Financial Review's Smart Investor magazine published a front cover story called 'VIP Stocks — 25 Companies that Grow Earnings Year after Year'.1 The 'VIP' tag in this case stood for 'Very Impressive Performers' and was a accompanied by a rather nifty photograph of what looked like a backstage pass.
The implication was that this was the portfolio favoured by insiders. The blue ribbon stocks were chosen after analysts "pored through consensus earnings forecasts for Australia's top 500 listed companies" to find the 25 that they agreed had the best potential in terms of earnings per share (EPS) growth.
This was a detailed and rigorous process, we were told. To ensure the chosen stocks were not "just a flash in the pan", the magazine's analysts insisted on a superlative track record. The companies had to have had at least double-digit EPS growth in both the 2005 and 2006 financial years, as well as "a top earnings outlook" for either 2007 or 2008.
To ensure the companies were generating earnings efficiently, the analysts required that each stock had a return on equity of at least 12 per cent. And to cover the risk that all the good news was priced in, they excluded any company with a price-earnings ratio "wildly above" the industry average.
So given these high hurdles, it would seem reasonable to expect that Australia's top analysts would create a small portfolio that would shoot the lights out, or at least outperform the market, wouldn't you think?
Unfortunately not. Of the 25 "very impressive performers" for 2008, only a mere seven (or less than a third) ended up performing better than the market, as defined by the S&P/ASX-300 Accumulation Index. They were Sonic Healthcare, Computershare, TechnologyOne, IBA Health, Iress Market Technology, Beach Petroleum and JB Hi-Fi.
On the flipside, 18 of the 25 underperformed the market. And of those, 12 lost 60 per cent or more of their value. In fact, the two worst performers in the magazine's list of "VIP" stocks went missing in action altogether. Investment companies Allco Finance Group and Babcock & Brown imploded over 2008 and now are no longer listed.
Overall, if you had decided to put your own money into this concentrated, "rigorously analysed" portfolio of Australian stocks last year, you would have generated an average return of a negative 58.58 per cent, against a negative 38.90 per cent return just by owning the market. And this is even before taking brokerage costs into account.
It should be clear from this that when you hold such a concentrated portfolio you are taking on unnecessary risk. You expose yourself to stock specific and industry factors that can blow your portfolio out of the water.
The fact is it doesn't matter how well those individual stocks have performed up until that point. More often than not, their superlative past performance is recognised by the market and is reflected in prices.
When it comes down to it, investment is about what happens next. We don't know what happens next. And that's why we diversify.
(The writer would like to thank Rob Brown for his assistance with this article)
1'VIP Stocks', Financial Review Smart Investor, June 2007