Out of the Blue
A recent article in a popular investment website advised investors that with Australia facing "strengthening headwinds", it was time to restrict one's portfolio to the bluest of blue chips. It was a familiar story.
Ten years before, at the start of a new decade, the call was going out to Australian investors via the media not to stray too far from the market leaders—the likes of Telstra, AMP, Tabcorp and Lend Lease were frequently quoted.
Yet, the wisdom of hindsight shows those four stocks made poor investments in the last 10 years. AMP was the worst, with a cumulative price only return from January 1, 2001 to December 31, 2010 of –67.75 per cent or –10.7 per cent annualised.
Telstra was also a miserable performer over the last decade. From being the biggest stock on the market in 2001, it moved down to ninth position and delivered a negative price-only return of 56.56 per cent or an annualised –8.0 per cent.
Other lousy blue-chip performers over the decade included News Corp (–42.71 per cent or –5.42 per cent annualised), Lend Lease (–46.28 per cent or –6.02 per cent annualised) and Tabcorp Holdings (–34.43 per cent or –4.13 per cent annualised). All figures are price only and do not include dividends.
Ironically, the best performers in the S&P/ASX 300 included many stocks that were either not in the index a decade ago or ranked very low. They certainly weren't considered blue chips.
Take Fortescue Metals, which a decade ago did not exist. Now, of course, Fortescue is a household name. It has delivered a cumulative return of 83,192 per cent over the decade, or an annualised 96 per cent, and by the end of 2010 was the 25th largest stock on the local market.
Likewise, once high-flying companies like Centro Properties and Paperlinx have transformed from large-cap blue-chips to small-cap stocks in the space of a decade.
Are you starting to get the idea? A blue-chip stock does not necessarily translate into a blue-chip investment. Indeed, the large and glamour stocks that newspapers tend to focus on tend to offer lower expected returns than small and out-of-favour (sometimes called 'value') stocks over the long term.
These small and value effects are not some quirk. On the contrary, they are evident around the world and have been documented by world-renowned financial economists such as professors Eugene Fama and Ken French.
Where most people go wrong in applying this research is to think they can pick the individual winners. Indeed, an entire industry, promoted through the financial media, is built up around this notion that picking stocks is the way to build wealth.
There is another way. And that is to target the overall risk dimensions of the market—choosing firstly how much stock to hold versus bonds, and then deciding how much to tilt your portfolio to these higher expected return small cap and value stocks.
This approach does not involve making individual stock bets, but targeting the returns of that particular part of the market through broad diversification, while filtering out stocks that for one reason or another don't fit the requirements of the strategy.
It may not be as exciting as picking from the same small pool of blue chips based on the recommendations of a newspaper columnist. But it is better for your longer-term financial health.