Down the Mineshaft

Success when investing doesn’t just mean knowing what risks to take. It also means avoiding the uncompensated risks associated with having large holdings in individual companies or investment sectors.

In February 2008, the global credit crisis was underway. With investors in a defensive mood, The Australian Financial Review suggested that the minerals resource sector of the market offered a port in the storm.1

“Investors are being urged to buy into resource stocks as the best defensive option in a rocky market,” the journalist wrote.

The rationale was that resource stocks had good cash flow, were insulated from issues in the debt markets and were leveraged to the China boom through strong demand for commodities such as coal, iron ore and copper.

A bevy of analysts supported the journalist’s theory, one of whom described a generational change in the markets that was turning conventional wisdom about investing on its head.

It all seemed to make sense at the time.

Resource-rich Australia, after all, was performing better than most other developed economies. In its quarterly monetary policy statement in February 2008, the Reserve Bank of Australia pointed to expectations of higher contract prices for coal and iron ore that year.2

But what if you had tilted your portfolio to resource stocks as a safety play back then? What if you had heeded the call from media commentators and brokers about getting more China exposure via a big bet on the miners?

Well, it turns out you would have done rather poorly. In fact, as the chart below shows, the worst performing area of the Australian share market over the subsequent five years has been the materials sector, which includes the miners.

The top performing sectors over that period have been healthcare stocks, financials, including the big four banks, and telecommunications stocks, mainly Telstra.

Sector performance


In other words, the sectors that many were steering clear of during the credit crunch in 2008 have been the top performers since then and the ones that the media and broking community were pushing as a “safe haven” has been the reverse.

This is not to recommend any specific sector in the future. But it does serve as a reminder that investing based on the economic headlines of the time or on sector views is an unreliable and unprofessional way of constructing a portfolio for the long-term.

What happens in the financial media is that editors and reporters get excited about particular sectors that historically have done well and build a coherent, forward-looking narrative around something that the market has already observed and priced in.

News is about what has happened in the past. That’s fine, but it’s not something you can build an investment strategy around.

Unless you are a rare individual who can foretell the future, you are better off diversifying – across individual securities, sectors, industries and countries.

Diversification is essential because it reduces uncertainty, controls risk and increases the reliability of outcomes. Diversification should not just be across individual securities, but across sectors, industries and countries. Markowitz’s PhD dissertation in 1953 was based on the concept of diversification. In 1990, Markowitz was awarded a Nobel Prize for his extraordinary research.

In any case, the driver of long-term portfolio performance in equities is not how many resource stocks you own, but the degree to which your portfolio is exposed to the dimensions of expected return identified by established academic research.

That means how much exposure you have to equities versus fixed interest, to small companies over large companies, to low-priced ‘value’ stocks over high-priced ‘growth’ stocks and to high profitability firms relative to low profitability firms. You may recall the $800bn Norwegian Sovereign Wealth Fund adopts the same approach as we do.  

This is a different approach to the one promoted through the media and much of the financial services industry, which promotes the process of long-term wealth management as making tactical shifts between one industry sector and another.

Of course, you might get lucky with this approach. We build our investment processes reflecting the drivers of risk and return, based upon evidence, not luck, which is unsustainable.

1 – ‘Suddenly, Cyclical is the New Defensive’, The Australian Financial Review, Feb 22, 2008
2 – Statement on Monetary Policy, Reserve Bank of Australia, Feb 2008

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Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.