Can stockpickers outperform the market?

One of the main reasons given for establishing an SMSF is having more control over what you can invest in, and for many this means having control over the shares you hold in your portfolio.

If you’ve chosen to establish an SMSF, chances are you think you’re pretty good at picking stocks (and investing in general), but the bad news is that the odds suggest you’re probably not. There may be a few of you reading this who think this is an unfair characterisation as you’ve had great success picking stocks, but as a collective we’re pretty hopeless.

DALBAR, a US based produces an annual report  called ‘The Quantitative Analysis of Investor Behaviour’. Their research shows that the average equities investor underperforms the market by 4.3% p.a.

So, why do most people think they’re good at stock picking and investing generally? Likely the same reason people think they are better than average drivers! It is a built-in evolutionary, behavioural bias that’s part of how we’ve been wired. This overconfidence serves us well in many aspects of our lives but can be quite destructive when we’re investing. Stock picking is actually a profoundly difficult occupation that shouldn’t be attempted by all but the most seasoned professionals.

A study by Bessembinder considered US stocks versus US Treasury Bills over the period 1926 through 2015. He found that less than a half of stocks actually beat the returns of one month Treasury Bills. This implies that you are statistically likely to get a superior return from cash than from single stock strategies!

On the flipside, research shows that the Australian stock market index beats the bank bill index around 88% of the time over rolling ten year periods.  This suggests that investing in domestic stocks in a diversified way, with a long term time horizon, provides you with pretty good odds of success.

However,  despite this compelling evidence, Australian SMSF investors have typically invested in a concentrated fashion,  picking a small number of stocks.  So why don’t more investors diversify broadly? Below is a brief list of some of the possible reasons why:

• Most investors are not schooled in finance and modern portfolio theory, so they don’t have a clear picture of how many stocks are required to build a truly diversified portfolio.
• Investors have a false perception that, by limiting the number of stocks they hold, they can manage their risks better.
• Investors confuse the familiar with the safe. They believe that because they are familiar with the company, it must be a safer bet than one with which they are unfamiliar.
• Overconfidence: Nobel Prize-winning economics professor at Yale, Robert Shiller, notes that “individual investors and money managers persist in their belief that they are endowed with more and better information than others, and that they can profit by picking stocks.”

If you have made any of these mistakes (I know I have), how could you look to manage your SMSF portfolio going forward?

The practice I work in runs with an investment philosophy founded in an “evidenced based” approach to portfolio construction. Or put another way if an investment or idea doesn’t stand up when scrutinised in a scientific way, it is rejected.

As we have seen, there is unnecessary and unjustifiable risks associated with holding concentrated portfolios of stocks, so we diversify broadly, both across and within asset class sectors. By way of example, a typical portfolio would hold the following:

• Australian Equities - circa 200 stocks
• Global Equities - circa 5,800 stocks
• Australian Credit & Bonds - circa 300 securities
• Global Credit & Bonds - circa 4,500 securities
• Real Estate Investment Trusts - circa 400 securities

How we then allocate between asset classes varies from client to client based on their own unique circumstances. The best way to describe this process is to start out with two sample clients. Let’s call one couple Jack and Jill, and the other Joan and Bob.

Two case studies

Jack and Jill, are both 40 and have managed to build up $600,000 in their SMSF. They really don’t think too much about their super and have 25 years until they can access it. They simply want to grow their balance as much as possible in that time.

Joan and Bob are both 70 and retired. They require $150,000 per year in cashflow from their SMSF to live off and have a $2,000,000 balance in their SMSF.  They are not too concerned about leaving a legacy in their super for their kids, as the kids will inherit the family home.

When investing for Jack and Jill, we are likely to have a much higher allocation to Australian and global equities (up to 80%) in large low cost funds. They are not focussed on their SMSF balance from year to year so can cope with market volatility and know from evidence that large index-based funds have outperformed over the long term so are happy to be invested that way.

When investing for Joan and Bob we are likely to have a smaller allocation to Australian and global equities  (closer to 50%) as they need to draw on the fund every year to fund their cost of living and are highly sensitive to the impact of share market volatility on their SMSF balance. They can not afford for their fund to fall by 40% which it might if 80% of the fund was in shares. Such a scenario could severely impact their standard of living in retirement.  

Joan and Bob also have a much larger balance than Jack and Jill. This means they may also be able to reduce their ongoing portfolio management costs by investing directly in ASX listed shares. The key here is not to pick a small portfolio of Australian shares as their only equity exposure.  Global and small cap funds should also be represented.  If they are to invest directly in Australian shares the key would be to own a minimum of 20 Australian shares diversified equally across all the major industries in the ASX and then systematically rebalance the portfolio back to its equal weights regularly.

Many of you will be saying: “I understand all of this, but I get a real kick out of picking stocks”. It may give you a thrill, much like picking a horse at the races.

If this is the case, that’s OK. But just be aware of the risks you are taking. Individual stock picking is an endeavour more closely resembles “buying a lotto ticket”, than considered long term investing.

If you can afford to lose some money and you get a thrill and enjoyment from stock picking – then continue to do so. You don’t need to feel bad about it. Just be sure to quarantine your stock picking activities in the “entertainment bucket” and don’t confuse the money you allocate there to the money you allocate to the “prudent investing bucket”.

It is also critical that you size your “entertainment bucket” in a manner that is appropriate for you, your needs and your level of resources. Your adviser can help you with this.

Cathryn Gross

Partner & Principal Adviser       

Minchin Moore Private Wealth Advisers

Cathryn has  over 20 years’ experience in financial services and is an accredited Executive Coach.

In 2015, Cathryn established her own financial advice practice which she merged with Minchin Moore Private Wealth in 2019. She is now a Partner and key decision maker in that practice.

Before moving into financial advice, Cathryn worked in  corporate finance and institutional sales roles at a global investment bank and large trading bank. 

Cathryn has been a finalist in the AFA Rising Star Awards and sat on ASICs Financial Advisers Consultative Committee. In 2019 she was also named by Financial Standard as one of Australia’s top 50, most influential advisers.