What’s the first thing you hear when you begin investing?
Our bet is it’s the same as one of the first things we heard as an investor.
At first glance it seems to be good advice. But when you look at it closely, it turns out it could be the worst advice investors ever take.
What are we talking about?
We’re talking about diversification – or as we prefer to call it, investment suicide…
One of the biggest fibs put around by mainstream investing pros is that investors should have balanced and diversified portfolios. They spin that yarn not because it’s the best advice, but because it suits them.
The more diversified your portfolio the less attention you need to pay to your investments.
That suits most of the financial services industry because it means they can cream off a few percentage points every year without having to do much work…and without having to talk to you.
They’re the same folks who, contrary to all the evidence before them, still tell you ‘buy and hold’ is still a winning formula for stock investing, when in reality it’s the worst form of investing.
Stock Pickers Beat Index Trackers
But we won’t dwell too much on ‘buy and hold’ versus active investing today. We’ve made our view clear on that over the past few years. Our view is that investors need to be active. That doesn’t necessarily mean trading in and out of stocks every day.
Being an active investor just means taking an active interest in your investments and your wealth. It just means frequently monitoring and adjusting your asset allocation.
The result is you’ll have more confidence in the stocks you pick. This gives you a better chance to outperform the broader index.
That’s important, because if you look at the performance of the All Ordinaries index going back to 1999, it has only gained 71.9%. That’s not terrible. But it’s not great either. So let’s see how the index stacks up against just a handful of blue-chip stocks:
Source: Google Finance
Every stock in this sample except Telstra [ASX: TLS] has at least doubled the performance of the All Ordinaries since 1999. Seeing that the five stocks we’ve chosen make up such a big part of the index, it just goes to show how a diversified portfolio kills returns.
Also, note the companies we’ve selected. They are big blue-chip stocks: BHP Billiton [ASX: BHP], Commonwealth Bank of Australia [ASX: CBA], Telstra [ASX: TLS], Westpac Banking Corporation [ASX: WBC], and Woolworths [ASX: WOW].
Those are big blue-chip stocks. If we’d picked a few small- or mid-cap stocks then the outperformance could have been even greater. But we wanted to give a genuine example of a handful of stocks many investors would have owned in 1999.
Of course, that’s all well and good, but won’t a diversified portfolio protect you in a falling market? Isn’t that the real point of having a diversified portfolio?
If that’s what you think you may be in for a surprise…
No Protection from a Diversified Portfolio
The following chart shows you the peak to trough for the same stocks and index from 2007 through to 2009:
Source: Google Finance
Not surprisingly given the nature of the financial meltdown in 2008, CBA shares fell the most, down 54.4%. But you’ll also note that the second worst performance was the All Ordinaries, down 53.7%.
In short, despite the tales you’ve often heard about diversification saving investors from falling markets, in this example the opposite is true. If you’d held these five stocks through the meltdown your portfolio would have dropped 38%.
While no one wants their stocks to fall, it’s still 15% better than the diversified index portfolio.
And if you had actively managed your portfolio, then maybe you could have sold out on the way down. But we won’t take that for granted. Besides, the point we’re trying to make is that diversification doesn’t always reduce your risk or minimise your losses.
In the case of the 2008 meltdown it actually increased your risk.
This shows the virtue of concentrating your portfolio into a small number of stocks that you’ve carefully picked out from all others. And while we aren’t a fan of ‘buy and hold’, even that strategy using just five stocks is better than a diversified ‘buy and hold’ strategy.
It just goes to show that over the longer term the conventional wisdom about buying a diversified portfolio isn’t necessarily true. Our view is (and our analysis confirms this) is that in order to build wealth, diversification isn’t the winning formula. The best approach is to pick a small number of individual stocks and actively manage them.
Cheers,
Kris+
From the Port Phillip Publishing Library
Special Report: UNAVOIDABLE: Australia’s First Recession in 22 Years
