When you compare the Australian market to the US, the difference is frightening. The Australian market is very concentrated (a handful of companies dominate the market), has nearly double exposure to risky ‘cyclical’ sectors and has almost no exposure to technology. I’m going to suggest (below) that you can solve most of these problems by investing in just two low-cost, index ETF’s to achieve better diversification.
Evidence of why diversification matters
Burton Malkiel’s thesis in his best-selling book, A Random Walk Down Wall Street is that stock market returns are random. There are no patterns. As such, trying to pick a stock or managed fund that will out-perform the market is akin to picking a needle in a haystack. Forget trying to do that. Just invest in the haystack (index).
Furthermore, research demonstrates that ‘mean reversion’ is long run hallmark of share markets. Mean reversion is the assumption that a stock’s price will tend to move to the average price over time. Essentially, this means that the winners in the next 1-2 years will probably be the losers in the following 1-2 years as returns level out.
In short, diversification is the key i.e. diversify so well that no one stock, sector, market and to a lesser extent, asset class can materially impact your annual returns.
Comparing the Australian market to the US
The table below demonstrates that the Australian market (ASX200) is very concentrated compared to the US market (S&P 500). And it is important to remind ourselves how insignificant the Aussie market is i.e. it represents less than 2% of the world index whereas US represents 52%.
It is no surprise that the Australian market is very heavy in just a few sectors such as financials and materials. It is also weak in technology.
The underlying risk and growth characteristics of each market are different too. The US market has greater exposure to defensive (safer) sectors and industries.
You can divide the market sectors into three categories:
- Cyclical – sectors that are impacted by economic cyclicals
- Defensive – sectors that are relatively immune to economic cycles; and
- Sensitive – which ebb and flow with the overall economy, but not severely so. It sits in between cyclical and defensive.
What does this all mean?
The Australian market is dominated by the big 4 banks, BHP, CSL, Wesfarmers and Telstra (i.e. top 8 companies account for 34%). In the last 12 months, the banks and Telstra have struggled. As a result, they have offset the good performance of BHP, CSL and Wesfarmers. This is evidence of what poor diversification does i.e. one sector or company shouldn’t have a material impact on your returns.
If you take the view that the big banks will struggle to produce the same returns that they have over the past 20 years (because of increased scrutiny amongst other things), then this might become a more regular event.
One idea: invest 60/40
If you invested 60% of your monies in an ASX200 fund and 40% in an ex-20 fund (i.e. a fund that invests in the companies ranked from number 21 to number 200 i.e. excludes the top 20 companies), you will achieve similar diversification to the US market in that the top 10 stocks would represent 25% of your portfolio and the top 20 approximately 33% of your portfolio.
Improved returns
Over the last 2-3 years, the ex-20 has nearly doubled the return of the ASX200 (approximately 22% versus 13% p.a.). For example, in the 2017 calendar year, the ASX200 increased by 12.11%. However, if you had have invested in a 60/40 mix, your total return for 2017 would have been approximately 15.40%. I don’t know if this performance will continue. However, I do know that the better diversification you have, the better the performance over time. The ex-20 index has outperformed the ASX200 since inception (March 2001).
The value of portfolio construction and thinking logically
This approach might not suit everyone, and it should not be implemented in isolation (i.e. there are many strategies and things to consider when constructing a portfolio). Plus, there are many ways to achieve better diversification in the Australian market e.g. passive (index) fund manager Dimensional already does this through its methodology.
The reason I wrote this blog is to demonstrates benefits of astute portfolio construction and the value of independent financial advice. Literally one idea (like this) could save or make you a lot more money. If you have a share portfolio (inside or outside super) but don’t have a robust methodology guiding how you have invested, then you might benefit from having a chat with us.
