The Special Sauce – I want some Alpha no Beta
As a Financial Adviser I often get asked what should I do with my money, where should I invest or what should I invest in. My answer will often depend on my mood, whether I feel like having some fun or how many pale ales I have had. The real answer is boring to most people, and I think to some, unbelievable.
However, the reality is that most economists and so called ‘market gurus’ get it wrong. A Duke University study of corporate executives found a dismal record of prediction. The executives gave 11,600 forecasts of the S & P 500 Index (The biggest 500 companies in the US) over 9 years. The survey found executives predictions of future returns was negatively correlated. In other words, they were crap.
In another example, The Australian Financial Review in 2009 advised readers to switch out of bank stocks and into a diversified portfolio of mining stocks such as Rio Tinto and BHP Billiton. Arguments at the time were that banks margins could only contract from here, recent performance was supporting the move. How did the forecast turn out? Bank stocks grew between 80 to 100% from 2009 to 2013. Rio Tinto over the same period 2.3% and BHP Billiton 6.4%. If you had owned the entire ASX 300 then your portfolio would have grown 37%.
So, what should you look for in an Adviser or an investment portfolio. The boring answer is that it depends what you want to achieve. However, here are some starting points.
Do you agree that over the long term shares beat cash investments? Ok, so if you want more growth than stability you should have more shares in your portfolio than cash or bonds. Depending on how aggressive or defensive you want to be will depend on the structure of the portfolio.
But what sort of shares should you buy or should you just buy a passive index fund? In the example above you would have been better off just owning every share in the ASX 300. Well, a passive index fund will give you the market return less fees and trading costs. Fees can be low in a passive fund, but trading costs can be high in a passive fund. What should you do if you want to beat the market?
Data over decades has demonstrated that certain shares outperform other shares over time. When I say over time that means long periods of time. Do shares beat term investments every year, no. So, what do these shares look like. Well, they are what are often referred to as small cap and value shares. Lets just call them small companies (that are actually still big but not as big as others) and cheap companies. Why, because these companies are riskier investments than large blue chip companies. A further type of share to look out for are those companies that demonstrate greater profitability than others. Fancy that. A company the makes good profits should be targeted. This stuff is rocket science.
So small, cheap and profitable shares beat larger more expensive shares over time. Small, generally beat large by about 2%. Cheap, beat expensive by about 3% and highly profitable beat low by about 4%. That is, they may not beat them every year or even every few years. Over time they will. You’ll get rewarded if you can stay in your seat and hang in there for the bumpy ride.
So basically, if you want to grow your money above inflation and the market then buy shares that are small, cheap and profitable. You could do that and do very well. However, that would concentrate your wealth into a small bundle of shares within any one market. This brings me to diversification.
As I mentioned there are premiums of offer from small, cheap and profitable shares over the long term. The problem is no one knows which ones. Some advisers, economists and neighbours that have just read the “Hot Picks” section of the local paper may think they do. The reality is they don’t. To capture those premiums you need to diversify your portfolio. So, buy an index and tilt towards cheaper, smaller profitable companies based on a predetermined definition. Then rebalance as those shares change in value.
This, I think makes logical sense. However, not everyone is logical. Investing can be very emotive, and some investors are very risk adverse. In these situations, I have learned that achieving better outcomes for clients involves compromise. Some clients have never owned a share in their lives. The thought of doing so is a scary prospect. They think their money sitting in a term investment isn’t the best thing to do with their money given the low returns. I’ve even had one client say to me “its brainless isn’t it”. Well, no. Investing isn’t all about returns. Investing is about endeavouring to create better outcomes. Having sleepless nights is not a better outcome.
So, for those that are very risk adverse I create a portfolio that incorporates the findings above but gives them more familiarity to their investments. Its like giving them a comfort blanket to take to bed. That will go some way to creating a better outcome over the long term.
The information in this blog is general advice only and may not be right for you. For advice specific to your circumstances please consult with an Authorised Financial Adviser.
- Posted by Isbister
- On September 5, 2018