'Why bother emulating average returns?' Don't over-diversify

For big multibillion-dollar superannuation funds run by slow-moving, conservative fund managers, the performance goal is not about stock picking but about slightly outperforming the market through asset allocation or, in the equity market, by going underweight and overweight sectors.

Big fund managers have too much money to be stock pickers. When you run a few billion dollars, you simply can't buy a mid-cap stock in any quantity without blowing it out of the water. And if you did it would make very little difference to your overall performance because the liquidity would prevent you buying a material holding. The result is that the big end funds can do little more, by virtue of their size, than offer you average returns.

If you are managing your own investments and your goal is to achieve an average return through a diversified portfolio, why bother? If you want diversification you can get that sort of exposure in a thousand places these days, so why would you bother trying to emulate those average returns through your own efforts?

Far better you pay 2 per cent to a fund manager who'll send you a letter once a year telling you how much money you've made. It's less risky, less stressful, and you get your evenings and weekends back. You also avoid a lot of expensive administration and time lost keeping track of everything for your self-managed super fund, accountant, auditors and any other third-party professionals feeding off your activity.

The one-click availability of professionally run diversified portfolios means that the only point of taking an interest in the sharemarket is because you want to significantly beat the averages, not match the averages, and there are only a couple of ways of doing that.

The first is by timing stocks. This can be done in big or small stocks. If you want a low volatility experience stick to the big stocks. Some people call this long duration trading. Timing the highs and lows in particular stocks or sectors. We do this in my newsletter through something we call the Top 50 Portfolio. This portfolio manages to achieve small but regular outperformance by timing big stocks and sectors in slow motion. It is a fairly relaxed experience. The game is to pick out the quality stocks, exclude the rest, and then slowly trade the preferred stocks, buying them on the sentiment dips and selling them when the price gets inflated or when the whole market tips over. All very well, but the experience we've had is that when playing in the big end, while we can marginally improve upon the averages, we generally end up with a result somewhere close to them.

That experience leads to the obvious conclusion that to achieve significant outperformance you really have to commit the time and energy to the intellectual challenge of stock picking in the small and mid-caps. Only here are you going to find the volatility and opportunity to make a difference to your financial worth. And what an opportunity it is. To give you an idea here is a quick calculation that might surprise you.

Take the top 200 stocks. Over the last year, the index is up 14.5 per cent before dividends. A very good year considering the market average is up 5.7 per cent a year since 1935. But the average return tells you nothing about the individual stock picking returns on offer. They were between minus 59 per cent (Mayne Pharma) and plus 262 per cent (A2 Milk). And this is where the opportunity of stock picking becomes apparent. If you had picked the top 20 performing stocks in the ASX 200 in equal size, you could have made a 74 per cent return in the past year. And if you avoided the 20 worst performing stocks in the ASX 200 you would have escaped an average of minus 30 per cent.

That's why people manage their own investments - they want to do better than the average, not match it. If you pick the right 10 stocks you can achieve 10 years' worth of average returns in one year, as you could have done in the last year. And that's just in the ASX200 in stocks with a market capitalisation of over a billion dollars. Imagine what's on offer further afield. And you do it because you enjoy the intellectual challenge. It can be a marvellous pastime when you get it right.

Still keen to diversify?

Marcus Padley is the author of the daily stock market newsletter Marcus Today. For a free trial of the Marcus Today newsletter, please go to marcustoday.com.au

This story 'Why bother emulating average returns?' Don't over-diversify first appeared on The Sydney Morning Herald.