KEY POINTS:
We all know that investment portfolios need to be diversified but unfortunately there is no consensus as to what diversified really means.
That's a shame because diversification is about as close to a free lunch as there is - the risk is substantially reduced without a significant fall in return.
To the investment managers of the NZ Super Fund diversification means lots of different managed funds investing in bonds, property, shares, venture capital, emerging markets, forestry etc. Diversity smooths out the ups and downs and if the worst happens the strategy is defensible along the lines of "we didn't do any worse than our competitors".
For Mum and Dad retail investors diversification can, for an annual fee, follow the NZ Super fund model. If however you are a DIY share investor with an eye on costs and an interest in the market it can also mean just 10 shares in New Zealand, five in Australia and a couple in the UK.
Unfortunately it is only after bad things happen, like Feltex or to a lesser extent Skellerup, that people tend to give the topic some serious thought.
Skellerup's profit warning the other day was unexpected.
The shares dropped by 20 per cent over three days and are down 38 per cent in 2007 versus a 4 per cent gain for the broad stockmarket index.
Skellerup is significant because although it is a small company it has been something of a favourite among Mums and Dads. Apparently there are about 5900 small investors with shares in Skellerup and a few big ones too including the AMP and the NZ Super fund.
Small stocks can have big impacts - even if Skellerup was just equal weighted in a 10-stock portfolio then its effect would be (assuming the other 10 stocks did as well as the stockmarket index) to reduce returns for the first six months of 2007 from a respectable 4 per cent to zero.
So which strategy is the right one: diversified with annual fees, or 10 stocks and hope for the best? Stockpickers will argue that buying the average is boring, dooms you to mediocrity and that it is easy to beat the market, which of course it is if you remember only your gains and conveniently forget your losses.
The reality is that the average is a pretty hard act to follow as Skellerup and Feltex shareholders will no doubt testify.
What is more, the academics tell us that owning just 10 stocks is not enough to give us the full benefits of owning a diversified portfolio.
In a paper entitled "Have Individual Stocks Become More Volatile", published in the May 2000 issue of the Journal of Finance, the authors make the point that individual stocks have become much more risky in the last 30 years, although overall market volatility has not increased.
In other words the benefits of portfolio diversification, the free lunch, have increased in the last 20 years or so.
Until recently conventional wisdom has held that a portfolio of 20 or 30 stocks confers most of the diversification benefits available from the market portfolio. However, the Journal of Finance study shows that in the period 1986-1997 investors needed 50 shares in their portfolio to reduce overall risk to the same level as was achieved by only 20 stocks some 25 years earlier.
This finding has important implications for private individuals: how many people could afford to have 50 different shareholdings of a reasonable size, say $5000 each? It therefore seems inevitable that most people who own individual stocks will have much riskier portfolios than they need to.
The authors break the volatility of an individual stock into three separate components - volatility attributed to the market, to the firm's industry and stock specific or idiosyncratic risk.
The analysis shows that while overall market volatility has not increased, the proportion of total volatility represented by the riskiness of the individual firm increased from 65 per cent in 1962 to 76 per cent in 1997 while the impact of industry and market risk reduced by about one-third.
The study speculates as to why stock specific volatility has increased over the last 30 years and suggests that this is due to the decline in popularity of conglomerates, the trend for companies to seek a stock exchange listing much earlier in their life-cycle, the impact of executive options and increased institutional ownership of stocks.
So how do institutional investors cope with small stocks like Skellerup? The truth is that they can't tell if a stock will be a Feltex or a success story like Mainfreight but their jobs are on the line so they diversify. If a fund manager rolled in to work one day and informed the Trustees of the XYZ pension fund that they owned only 10 New Zealand stocks - one of which was Skellerup - the fund manager could well lose his or her job.
Fund managers are always telling potential clients that they have complex risk management systems that will minimise the impact of disasters like Feltex. Foremost among these complex systems is a simple strategy called closet indexing whereby you build a portfolio having regard to the relative size of each company. This means you generally avoid making really big, really dumb decisions.
However, if the totally unexpected happens and a big stock like Telecom goes bust you won't lose your job because everybody else has made the same mistake.
The NZX-50 index of the 50 largest stocks has a total value of about $50 billion.
Skellerup is a small stock capitalised at about $100 million so its weighting in the index is just 0.2 per cent.
Because fund managers must be seen to be diligently searching for undervalued stocks, companies like Feltex and Skellerup regularly pop up on their radar screens but because even they can't be sure whether a stock is genuinely cheap or about to bomb out they hedge their bets by having low weightings in small stocks and higher weightings in big stocks.
Market reality is that DIY investors who employ a value strategy focusing on shares which look cheap risk ending up with a portfolio of stocks with poor futures because the rest of the market knows that their share prices properly discount their uncertain prospects.
Anyone who has been a stockbroker or financial planner in the last 20 years will have seen numerous instances of "not-so-well funded retirements" due to overexposure to one or two poor performing stocks. Picking 10 stocks is more a game of chance than a reliable investment strategy.
* Brent Sheather is a Whakatane-based investment adviser