Down the Investment Mineshaft

Success in investment doesn’t just mean knowing what risks to take. It also means avoiding the uncompensated risks associated with laying out big bets on individual companies or sectors.

In February 2008, the global credit crisis was underway. With investors in a defensive mood, The Australian Financial Review suggested that the minerals resource sector of the market offered a port in the storm.1

“Investors are being urged to buy into resource stocks as the best defensive option in a rocky market,” the journalist wrote.investment market and stocks

The rationale was that resource stocks had good cash flow, were insulated from issues in the debt markets and were leveraged to the China boom through strong demand for commodities like coal, iron ore and copper.

To support her theory, the reporter lined up a bevy of analysts, one of whom described a generational change in the markets that was turning conventional wisdom about investing on its head.

It all seemed to make sense at the time. Resource-rich Australia, after all, was performing better than most other developed economies. In its quarterly monetary policy statement in February 2008, the Reserve Bank of Australia pointed to expectations of higher contract prices for coal and iron ore that year.2

But what if you had tilted your portfolio to resource stocks as a safety play back then? What if you had heeded the call from media commentators and brokers about getting more China exposure via a big bet on the miners?

Well, it turns out you would have done rather poorly. In fact, as the chart below shows, the worst performing area of the Australian share market over the subsequent five years has been the materials sector, which includes the miners.

The top performing sectors over that period have been healthcare stocks, financials, including the big four banks, and telecommunications stocks, mainly Telstra.

 

Sector performance
Sector performance

 

In other words, the sector that everyone was steering clear of during the credit crunch in 2008 has been a top performer since then and the one that the media was pushing as a “safe haven” has been anything but.

This is not to recommend any sector going forward. But it does serve as a reminder that investing based on the economic headlines of the time or on sector views is an unreliable way of building a portfolio for the long-term.

What happens in the financial media is that editors and reporters get excited about particular sectors that have done well and build a coherent, forward-looking narrative around something that the market has already priced in.

News is about what happened yesterday. That’s fine, but it’s not something you can build an investment strategy around.

Unless you are a rare individual who can foretell the future, you are better off diversifying – across individual securities, sectors, industries and countries.

Diversification is essential because it reduces uncertainty, controls risk and increases the reliability of outcomes. Diversification should not just be across individual securities, but across sectors, industries and countries.

In any case, the driver of long-term portfolio performance in equities is not how many resource stocks you own, but the degree to which your portfolio is exposed to the dimensions of expected return identified by established academic research.

That means how much exposure you have to equities versus fixed interest, to small companies over large companies, to low-priced ‘value’ stocks over high-priced ‘growth’ stocks and to high profitability firms relative to low profitability firms.

This is a different approach to the one promoted through the media and much of the financial services industry, which says you can build long-term wealth by making tactical shifts between one industry sector and another.

Of course, you might get lucky doing it that way. But then again you might not. And relying on luck has not been shown to be a sustainable investment strategy.

It can be a long way down to the bottom of the mineshaft.

 

Written by Jim Parker, Vice President, Dimensional Fund Advisors Limited 

Image courtesy of Victor Habbick / FreeDigitalPhotos.net


1. ‘Suddenly, Cyclical is the New Defensive’, The Australian Financial Review, Feb 22, 2008

2. Statement on Monetary Policy, Reserve Bank of Australia, Feb 2008

About Rob Pyne

Rob loves helping people make smart choices with their money so they have the highest probability of achieving their goals. He does this by helping them get financially organised and keeping it that way.

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