Is it back to the pre-GFC ways or do we need new rules for this environment? Ron Bewley explains

Constructing an equity portfolio used to be easy. Ask almost anyone how they were going between 2003 and 2007 and I suspect the answer would have been, “pretty good” – maybe not beating the index, but more than good enough.  Then the global financial crisis (GFC) arrived.  Even those investors who got into cash, for whatever reason, at the top of the market are probably struggling to get back into shares after such a rapid rise since the market bottomed on March 6, 2009.  

Will there be a pullback? What happens when/if the US has to implement an exit strategy from its stimulus package?  Because stock prices had been moving pretty closely together for years (2003-2007), even many badly-constructed portfolios probably did OK. Of course, even then, it was pos­sible to go wrong but, by and large, investors should have managed.  When the GFC arrived stock prices started to head in all directions, so proper diversification suddenly be­came so important. Of course, long-only portfolios are going to go down in a bear market, but well-diversified portfolios should be more resilient.  There were strong signs at the beginning of 2008 that the financial sector was getting much more risky while health care and utilities were not.

It was also the case that the blue chips fared better than small caps. As we show in the table, if you invested $100 in each of the top 50 stocks (big caps), the next 50 (mid caps) and the next 200 (small caps) – collec­tively, they make up the S&P/ASX 300 Accumulation Index – from November 1, 2007 (near the top of the market) until the end of August 2009, then the bigger the market capitalisation, the better your return.  The difference was even more striking at the bottom of the market! The reverse is true from the March 6, 2009 bottom to the end of August 2009 and during the bull run – March 1, 2003 to November 1, 2007.  It is tempting for many to take a small-cap exposure now to get a bit more outperformance in the current bull market – but beware! The ac­companying chart tells the long-run investor’s story of investing $100 in each index from January 1, 1994 – the start of these indexes.

The big caps to small caps ratio climbs over the period showing that big beats small by about 60 per cent over the whole period. The journey, however, was bumpy. A similar story is true for big caps to mid caps, but the relative gain is much less at about 20 per cent. Mid caps beat small caps, but most of the gain was made in the steeply rising period 2000-2003 when the market was falling in the wake of the tech wreck and 9/11.  The correlations between these indexes are all about 0.9. Far too big to try and build an effective and stable diversification strategy across market capitalisation. So we think that sticking with the top 100 might be the way to go.

The top 50 doesn’t include enough stocks from some of the smaller sectors to get adequate diversification.  True, there will be times when the top 100 lags. But like the tortoise and the hare, short bursts of speed don’t always lead to a win in the end.  Of course it doesn’t hurt to have a little small cap exposure if you like the excitement of watching some blossom (and others fail!), but the main game is at the big end of town.  So with the rapid run up from March 6, 2009 how should a “good” portfolio look now? Of course, many of us claim our successes of the past after the event, but how clear really is the future?  Unless you know you can time the market – in real time – then keep your head down and invest for the long run and stay well diversified in the top 100.

Boring, but nice.

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