One Simple Way to Help Cut Stock Market Risk

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I was having dinner with a stockbroker about 10 years ago. An industry veteran, he had been in the game close to 40 years. As we jumped from one topic to the next, all I could think of was one burning question.

Through all the cycles he had seen, all the trends, all the booms and busts, all the fads, all I wanted to know was this. What, in his experience, was the most proven way to make money out of the stock market over the long term?

Without hesitation, he reflected on two of his clients who had done far and away better than any of his other customers. Now elderly, these two sisters had amassed a small fortune by building up a position in just one company, bit by bit, year after year.

The company was BHP. It all started when their father bought them a small number of shares each for one of their birthdays. Over time, he bought them a few more. And a few more. So by the time they started their adult lives, their small holding was starting to grow into something substantial.

Throughout their lives, they added a few more shares to their collection whenever they could spare the money. If they couldn’t afford to, they didn’t. The point he made was this. The two sisters had never sold any of their shares. Nor did they have any future plans to do so.

He further observed that the sisters’ combined wealth just about surpassed the bulk of his other clients put together.

I’ve often thought about this story because it touches on many themes to do with investing. It certainly highlights the value of compounding, a concept most are familiar with. But the thing I always come back to is this.

As unlikely as it might seem now, what would have happened if BHP had gone bust?

To diversify or not?

When you pick up a finance book or read a magazine article about diversification, it doesn’t take long before you come across a lot of different theories. Theories on Asset Allocation. Theories on Optimisation. The Efficient Frontier. Fancy names, but what do they mean?

Much of it derives from the work of Harry Markowitz. In the 1950s, a finance journal published his ideas about portfolio management, which would become known as Modern Portfolio Theory.

Markowitz wanted to understand the relationship between risk and reward — a concept every investor must confront. His work focused on one key principle. That a rational investor would want to achieve the highest return for the least possible risk. Makes sense so far, doesn’t it?

But where his work differed was how an investor should go about it. Up until that point, investors had typically bought shares based on each company’s individual risk and return profile. What Markowitz proposed was that investors could achieve the same potential returns (whilst at the same time lowering their overall risk) by buying shares in a diverse group of companies.

For it to work, investors needed to buy shares in non-correlated companies. So instead of just buying shares in mining stocks, for example, they would buy shares in a range of companies from different industries and types.

It sparked a great deal of debate at the time and spawned a whole new type of finance theory. And on the surface, it makes sense doesn’t it?

Does it pass the common sense test?

Let’s say we have two investors who both have $10,000. Investor A puts all their money into a mining company paying a 5% dividend. Investor B decides to put half their money into the same mining company. They then put the other half into a bank stock that also pays a 5% dividend.

Both will expect to receive $500 in dividends. But what happens if the mining company reduces its dividend, or goes out of business?

Investor A has all their money tied up in just the one company. That puts their entire investment at risk. At least Investor B has their bank shares to fall back on. Surely Investor B’s strategy is safer and therefore smarter?

Or is it? What if instead the mining company thrives and makes even bigger profits and pays out even higher dividends, while the bank shares stagnate? Investor B has forgone the full upside of the mining company by buying shares in the bank stock — stock they bought to help reduce their risk.

Is diversification just another dirty word?

Modern Portfolio Theory has is detractors. They argue that it is after all just a theory. The way they see it, buying shares in a company is first and foremost about buying into the actual business. To them, each share purchase is a stand-alone proposition.

They believe that you should have the conviction to buy a stock if you think that it’s undervalued. If you don’t have this conviction, then you shouldn’t buy shares in the company.

These value-type investors try to reduce risk by not investing in certain industries. They want to avoid the chance of a good company with solid management losing money due to something out of their control. Like a depressed commodity price for example. Or a product becoming redundant.

So an investor needs to think about how good they are at picking individual, undervalued stocks. And if so, do they have the stomach to stick with them even when the market goes against them?

What to do?

Investors firstly need to do what makes the best sense to them, and that which reflects their individual requirements.

For many, diversification makes sense. It’s hard to pick what an individual stock will do one, three or five years out. Equally hard is predicting which sectors in the market will grow, and which ones might contract.

Diversification helps you overcome the concentration of risk that comes with owning just a single or small group of stocks. It helps reduce the impact that a big hit in one shareholding might have to your overall portfolio and wealth.

Where to start

One place to start is what the industry refers to as GICS. Although a mouthful, GICS is short for Global Industry Classification System. It divides all the shares listed on the ASX into 10 main categories. Some of the categories are then further broken up into sub-groups and industry types.

However, the idea behind it is that is that it helps money managers diversify their risk by allocating funds into different market sectors. You might find it useful going through some of the different sectors and having a look at some of the companies that belong to it.

In the table below, you can see the 10 main sectors on the left. On the right are some examples from each of these sectors.

GICS category

Examples of Shares per category — ASX

Energy

Woodside [WPL], Oil Search [OSH], Caltex Australia [CTX]

Materials

BHP, Rio Tinto [RIO], Nufarm [NUF], Orica [ORI]

Industrials

Toll Holdings [TOL], Bradken [BKN], Leighton [LEI], Seek [SEK]

Consumer Discretionary

Myer [MYR], News Corp. [NWS], Tabcorp [TAH], Crown [CWN]

Consumer Staples

Coca-Cola Amatil [CCL], Woolworths [WOW], Wesfarmers [WES]

Healthcare

CSL, Ramsay Health Care [RHC], Sonic Health Care [SHL]

Financials

ANZ, Macquarie Group [MQG], Perpetual [PPT], Westpac [WBC]

Information Technology

MYOB [MYB], IRESS [IRE], Computershare [CPU]

Telecommunication Services

Telstra [TLS], Spark New Zealand [SPK], Hutchison Telecom. [HTA]

Utilities

APA Group [APA], AGL Energy [AGL], Ausnet Services [AST]

 

Now take a look at your own portfolio. Does it seem balanced, or is it overweight in certain sectors? Picking the right sectors can lead to outperformance when you get it right. But it can increase losses on your portfolio if you get it wrong.

Buying shares in companies from a broad range of sectors might just be a way to maintain or enhance your returns, while at the same time helping to reduce your risk.

Regards,

Matt Hibbard,
Income Specialist, The Daily Reckoning Australia

Editor’s Note: This article originally appeared in Money Morning.

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The Daily Reckoning
The Daily Reckoning offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, The Daily Reckoning delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors. Founded in 1999, The Daily Reckoning is published in 7 countries with a worldwide readership of almost 1 million people.
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