Do direct investors need protection from themselves? Jonathan Ramsay argues taking into account the fundamentals of the underlying investments will pay off better than going for textbook diversification.

"Stocks and bonds are what he called evaporated property. People completely lose touch of the underlying assets. It’s all paper – these esoteric devices. So it has become evaporated property squared. I call it evaporated property cubed.” – Author Tom Wolfe citing economist Joseph A. Schumpeter.

Schumpeter wrote about the tendency for intermediation in financial services to lead to increasingly disengaged retail investors as early as 1942.

Yet product innovation has since continued to flourish in the form of managed funds and, lately, the ever-more-complex structured products that Wolfe alluded to.

It’s easy to be cynical, and retail investors increasingly are, but it’s also easy to forget where we have come from.

Even otherwise financially literate luminaries such as Isaac Newton and John Maynard Keynes dusted personal fortunes on narrowly aimed punts on the stock market.

It is still relatively commonplace for US investors to invest their entire pensions in the company they worked for all their life.

By and large, American economist Harry Markowitz did investors a huge service by kicking off the Modern Portfolio Theory movement in the 1950s, and with it notions of diversification, correlation and methodical portfolio construction.

Now we seem to be headed back to the past, with individuals drawn to directly held portfolios consisting of a handful of blue chip stocks in preference to the art, science and infrastructure of modern managed portfolios. Part of this is a post-GFC fear of being taken for an out-of-control ride on the markets.

It could also be part of a more general rise in public cynicism that has seen people question the belief that markets, governments, technology or a combination of each can solve any problem.

However, investors do need to be aware of the potential pitfalls of this approach, particularly in the narrow Australian market.

Modern portfolio theory strongly suggests that a well-constructed portfolio requires at least 15-20 stocks to attain appropriate levels of diversification and that consideration of the relative volatility of, and correlation between, stocks is crucial.

In practice outcomes appear to depend on the time and place as much as principles of portfolio theory.

We have done some modeling of simple portfolios consisting of five bluechip stocks in different regions of the world to see just how different outcomes could be in the absence of proper diversification, and compared the results with the performance of local indices (arguably the most diversified portfolios at a local level).

The blue chip portfolios consisted of the largest and usually most well-known stocks in the US and UK indices in the year 2000 and in Japan in 1990.

The hypothesis here is that investors are most confident going it alone when their national business champions have done particularly well, which is arguably a contributing factor to Australian investors’ comfort with the banks and big miners.

It turns out that the US investor’s portfolio of five stocks would have given a relatively diversified exposure to the US economy and would have followed the index quite closely over the following 10 years (see Chart 1).

As it happens, this portfolio would also have been surprisingly contrarian at that time as the largest companies had been left behind by the technology laden Nasdaq during the 1990s, which is also where most retail investors’ attention would have been focused.

The UK portfolio, on the other hand (see Chart 2), benefited in risk-adjusted terms from its bias to global pharmaceutical companies which chose to retain a London listing and subsequently proved somewhat defensive during the GFC.

The experience of the Japanese investor following the market rout of the early 1990s is even more influenced by the peculiarities of the time (see Chart 3).

If Mrs Watanabe had bought a few banks and a couple of national champions such as Toyota and Sony for her portfolio she would actually have done much better than retaining exposure to the broader market.

This was specifically because the Japanese government introduced policies to keep the banks afloat and implicitly support exporters through a favourable exchange rate.

Even more importantly, this was during a period of global expansion when exporting technology products and consumer durables was a particularly good business to be in.

So what about in the here-and-now, in Australia? First of all, ours is a concentrated market and buying the largest stocks will, unlike in the US, give you some very specific biases which you need to have a view about.

Specifically a typical bluechip portfolio would probably see the investor holding BHP, RIO, Commonwealth Bank, ANZ and Westpac, a group that would have outstripped the performance of the local market throughout the noughties .

More recently, however, cracks have appeared in this “True Blue” chip strategy. In 2010, when the local market fell by 11 per cent, the True Blue portfolio plunged 21 per cent and since then it has lagged in absolute terms (2 per cent per annum returns vs 6 per cent for the All Ordinaries).

It has also fallen by a greater amount than the market every time global sentiment has become more risk averse (see Chart 4).

So, do investors need to be protected from themselves or will a handful of Australian blue chips work out longer term and be a fair and transparent approximation of the ASX?

Unfortunately, portfolio theory does not really provide a universal prescription, given the variability of outcomes described above – diversification does not always produce a better outcome just by itself.

Rather, the fundamentals of the underlying investments need to be taken into account. In this case a blue chip Australian portfolio is really a leveraged bet on Australian housing and a global recovery.

Even if investors seek to diversify further down the market capitalisation ladder, it remains likely that direct, concentrated portfolios with a large cap bias will amplify the concentrated nature of the local market and economy and, successful or not, will be a relatively risky proposition with a pro-cyclical bias.

Ultimately it is up to the client whether they wish to be exposed to this, but it may well be at odds with their initial instinct to retreat to the relative “safety” of national champions.

On balance we would maintain that there is some inherent downside risk that needs to be managed, which is also a reason why an index approach is not an appropriate solution to a concentrated market either.

Perhaps the sensible middle ground for clients that need a greater level of engagement with their investments is a concentrated Separately Managed Account (SMA) with a style that fits the client’s time horizon and outlook.

For instance, a portfolio with an absolute return objective could significantly even out the strong biases in the local market, while a more growth-orientated product might provide a more even spread of “growth bets” than the True Blue portfolio.

Either approach is likely to add value in risk-adjusted terms. The other major advantage of an SMA is that the client can see more transparently what they are invested in, which can restore to them a sense of control while also providing the oversight of a professional manager who can ensure appropriate diversification, as Markowitz intended.

While it is true that, as an industry, we have often over-diversified portfolios and introduced too much intermediation, clients may well be jumping out of the frying pan and into the fire by going it alone.

Jonathan Ramsay is the head of asset consulting and strategic research at van Eyk Research.