We wrote about portfolio diversification a while ago - we related how a 15 - 25 stock portfolio can give you 90% of the benefits of diversification and how a 40 stock portfolio can give you 99% of the benefits. (Diversifying away non-systemic - company specific - risk is important in achieving the highest possible return for the amount of risk taken). We work hard educating our clients on the importance of building properly diversified and appropriate portfolios consisting of stocks and bonds. Properly diversified to us means eliminating all unnecessary risk while appropriate means putting our clients at a risk (and return) level that works for their financial situation and temperament.
But what about individual stock selection? If strategic asset allocation (the percentage of a portfolio allocated to stocks, bonds, real estate, commodities, and cash) accounts for most of the variation in returns over the long run (and it does), why even bother with individual security selection?
A very good question indeed!
Because we can add to returns with careful security selection and reduce taxes through tax loss harvesting. The empirical evidence overwhelmingly shows that we can outperform the market using a common sense approach to investing - buying businesses when they are trading for less than a knowledgeable buyer would pay for the entire company in an arms length transaction. In other words, buying companies when they are trading cheaply. It only makes sense! An investor should outperform the market over the long run by purchasing undervalued businesses and avoiding overvalued businesses - and the academic data supports that view.
How is it possible that the market is inefficient enough to give value investors a known edge over other types of investors? Economics 101 teaches us that excess profits in a capitalistic system are eventually competed away. Why don't the majority of investors recognize that value investing brings superior returns and join the gravy train?
The answer lies with some well-known investor biases that endure, despite wide recognition that they exist. People will be people! It is estimated that only about 10% of investors are value investors while the other 90% chase growth and momentum. Value investors are able to take advantage of investor biases which create excess profit opportunities for them. For instance, investors routinely associate good companies with good investments and are willing to pay a premium for them in the stock market. The Behavioral Finance term is "representativeness". Good companies are usually widely recognized as such and are highly priced as a result - and on average they under perform the market going forward. Likewise, investors routinely associate low growth (bad) companies with poor investments and shun them, creating a profit opportunity for the savvy value investor.
As well, a majority of investors expect stocks with poor liquidity (thinly traded) to have lower returns, yet the empirical evidence shows otherwise. Also, investors expect lower returns from stocks that are not widely followed by the financial analyst community, yet the evidence contradicts that expectation. Less widely followed stocks actually tend to outperform.
It really isn't rocket science. Rather, it is having the patience and discipline to buy a good company at a great price (or a great company at a good price) and waiting for the herd to recognize that it was overly pessimistic. It is also about having the discipline NOT to buy a stock just because the entire stock market it rising. We will not pay up for an investment - ever! Price discipline makes for successful investing and we never forget it at Biechele Royce Advisors. Although we aren't willing to market time per se, we are willing to let cash build up in our client accounts if we can not find good businesses at great prices or great businesses at good prices. Price discipline is risk management and risk management is a must during a secular bear market.
