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No brains needed

Created:

5 January 2009

Updated:

13 March 2009

Written by:

Chris Dillow

Could it be that the stock market is efficient, in the sense that you can only out-perform it by taking on extra risks? The performance of our no-brain portfolios in 2008 - a year when risks materialized most nastily - suggests it could be.

Those portfolios that do take extra risks had a horrible 2008. Our value portfolio - the 20 highest dividend yielders - fell 69.8 per cent and out high beta portfolio dropped 56.1 per cent. This suggests that the previous good performance of these strategies - in the two years before the credit crunch began on 1 August 2007 they out-performed the FTSE 350 by 3.9 and 27.9 percentage points respectively - was a reward for taking on additional risk. In the case of high beta stocks, the risk is simply their higher covariance with the market. For value stocks, the danger is that these'll do especially badly in an economic downturn.

A similar thing is true of our momentum portfolio - the previous quarter's 20 biggest risers. In the three years to May 1, this did very well, rising 92 per cent against the FTSE 350's 28.3 per cent. Over the summer, however, it did even worse than the market, as its exposure to commodity stocks hit it hard.

This suggests that the good long-run performance of momentum investing might not be a free lunch, caused by investors' tendency to under-react to news. Instead, it might just be a pay-off to a bet. Momentum investing is, in effect, a gamble that the conditions that favoured some stocks in one period (such as easy money) will continue to favour them in the next period. In the summer, this gamble failed.

What's more, portfolios that took less risk did relatively well in 2008. Our low-risk portfolio lost 20.2 per cent, compared to the 350's 32.5 per cent drop.

However, this fall is just what you'd expect given the beta on the portfolio. This seems to vindicate a prediction of the capital asset pricing model, which says that a portfolio of defensive shares should do no better on average than a mix of cash and a tracker fund.

There is evidence that defensives do better than they should over the long-run - but this doesn't come from recent months.

There's another message here for stock-pickers - market risk is ubiquitous. No basket of stocks can reliably avoid it.

Our chart shows this for our momentum and low-risk portfolios. In outline, these performed similarly to the market, having a bad January, good spring and awful summer and autumn. Even good stock-picking, then, exposes you to lots of market risk.

In these sense, asset allocation - the question of how many shares to hold - matters more than the question of stock-picking, which shares to hold.

Which raises the question: what's the point of these benchmark portfolios? They are meant to test hypotheses, to show how markets work. So, if the market recovers this year, I'd expect the high beta portfolio to out-perform and the low-risk one to under-perform if markets are efficient. And I'd expect value stocks to do well if or when the economy looks like recovering.

Also, these portfolios should under-perform any active investor. They are created without any thought at all, merely by following simple rules. If research and thinking add value, therefore, stock-pickers should do better than them.

But this has not been the case in recent years. According to Trustnet, only two of 233 all companies unit trusts have beaten our momentum portfolio in the last three years, and only four have beaten our low-risk portfolio. Which, in a sense, is another vindication of the much-maligned efficient market hypothesis.

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