Wednesday, April 14, 2010

Mission Impossible

 Jim Parker, Vice President, DFA Australia Limited

It's a Hollywood staple. A group of ragtag desperados is assembled to embark on a suicidal mission — think 'The Dirty Dozen' and 'The Magnificent Seven'. It makes for exciting viewing, but applying this approach to investment isn't recommended.

At the height of the bear market in early 2009, Australia's BRW magazine, a popular weekly business title, asked 50 market experts to draw up a roadmap for the anticipated recovery, including the best sectors and stocks to buy.1

The panel of 50 participants comprised fund managers, equity strategists, economists, analysts and other tipsters. From their recommendations, the magazine put together 18 "expert ideas" for the recovery.

The dozen and a half individual stock tips were split broadly between big, well-known, blue-chip companies such as QBE Insurance, BHP Billiton, Woolworths, Westfield, CSL and Boral — alongside some mid-caps, smaller stocks and outright speculative plays.

While couching its stock tips with a host of qualifications — nothing was certain, markets rarely followed a neat script and blindly relying on history was dangerous — the magazine said these were the pick of the bunch.

For the reader wanting to position themselves for the recovery, it might have seemed a reasonable assumption that assembling a concentrated portfolio comprising these 18 super stocks would be a good strategy.

But while parts of the magazine panel's ideal portfolio did do well — mostly the very small, speculative companies — only seven of the 18 stocks overall outperformed the wider market's near 40 per cent gain in 2009.

Indeed, many of the tried and true blue chips in the list underperformed the market. QBE Insurance gained just 5.3 per cent over the year, Woolworths rose 9.1 per cent and CSL actually went backwards, down 1.5 per cent.

If investors had assembled the BRW's 'rebound' portfolio at the start of 2009 and held each stock at its market cap weight, they would have seen a return of 26.8 per cent over the ensuing 12 months.

While that may sound great, it's worth pointing out that just by owning the broad market, as defined by the S&P/ASX 300 accumulation index, investors would have enjoyed a return of 37.6 per cent, a 40 per cent improvement on the magazine's ideal portfolio.

Holding a highly diverse portfolio of value stocks would have delivered an event better result. For instance, Dimensional's Australian Value Trust, with 187 stocks, posted a return in 2009, net of fees, of 43.6 per cent.



Holding such a broad range of companies in a portfolio is called diversification. It allows the investor to capture broad market and economic forces, while reducing the uncompensated risk arising from individual stocks.

This isn't to say you can't beat the market by assembling a focused portfolio. But these successes are usually more down to good luck than good judgement and they are very hard to repeat. It's like taking a punt on a horse.

In any case, as we've seen in the above example, even a portfolio assembled by the best and brightest can come up short of the mark. What chance, then, has the ordinary investor of generating consistent market-beating returns by relying on a handful of securities?

At the end of the day, gambling on a band of hand-picked individuals might work for Yul Brynner and Lee Marvin in the movies, but trying to build long-term wealth with a handful of stocks looks like mission impossible.


1'Waiting for the Rebound', Tony Featherstone, BRW magazine, Jan 8, 2009