Getting good returns in the sharemarket

Published in the Financial Planning Magazine, August 2008 by Dale Gillham

It is often said that the returns generated by managed funds result from the general movements in the market rather than from good management. 

While these movements can contribute to solid returns for investors, a lot can be done to minimise any downside so as to capitalise on the upside.

Given this, my intention is to share with you some insights into how you can assist your clients achieve better returns using direct share investments and what we can expect in the share market over the coming year.

In the last financial year the All Ordinaries Index fell 16.95 per cent although many direct share portfolios experienced losses far greater than this. 

The reason behind this is that traditional ‘safe’ sectors used for direct portfolio construction, such as Financials (-40.05 per cent), Consumer Discretionary (-39.97 per cent), Industrials (-30.62 per cent) and Utilities (-22.24 percent) all fell heavily. 

The only two sectors to perform in the ASX 200 index during FY 07/08 were the Energy (27.8 per cent) and Materials (4.33 per cent) sector.

Age old argument

There has always been a raging argument between those who promote ‘time in the market’ and those who support ‘timing the market’. Many claim that ‘market timers’ run the risk of being out of the market at the trough of a decline when sentiment is at its most negative and potential returns are at their greatest.

To substantiate this argument it is suggested that if you are out of the market on the 20 days that the market rises the most, your return will be substantially less than envisaged. However, the inverse of this argument is that if you are out of the market on the 20 days that the market falls the most, it stands to reason that an investor’s returns, by limiting the downside, would surpass the market average.

While both arguments have validity at certain times, a combination of both theories leads to better returns for investors in the long run. Obviously, between March 2003 and August 2007, ‘time in the market’ certainly worked well, however, since then ‘timing the market’ would have worked far better.

The anecdote to loss

Recently I have seen several portfolios with losses on individual positions of between 50 per cent and 90 per cent, which has an extremely negative effect on a portfolio’s overall performance. 

Of course, there is always the argument that good shares will rise back up to their previous value, but the question is ‘when’? 

While the investor rides out ‘time in the market’ they are not only potentially losing capital but also the opportunity to invest their funds in other assets that are rising.

Interestingly, investors will often ride out a losing stock rather than liquidate it for fear of loosing and sell winning stocks because they fear taking additional risks with stocks in which they have already made money. 

Unfortunately, this results in the investor achieving what they fear most.

Telstra is a perfect example of why investors would have been better off selling their shares given that it fell over 60 per cent in price over the six years between February 1999 and August 2006. 

A simple exit strategy (such as a stop loss) would have been enough to preserve capital, which in itself would potentially have improved the performance of portfolios holding this stock.

Similarly, in the past 12 months the use of a simple stop loss to ‘time the market’ would have minimised the losses on many portfolios. 

As a general rule of thumb, once a stock has fallen in price by 15% it should be sold to protect capital.

Market prediction

The landscape of the Australian share market is changing from one that has been dominated by financial and industrial shares over the past 20 years to one that is now dominated by resources and commodities. 

With this shift will come the need to adjust our thinking in how we manage portfolios and the ability to be more flexible in our approach.

In the short term, I don’t believe a buy and hold or ‘time in the market” approach will reap rewards, rather an active ‘timing the market’ approach will.

So where will the opportunities come from in the next 12 months? 

Stocks in the energy, healthcare, and information technology sectors will perform better over the coming year. 

And while stocks in the financials and utilities sectors have been oversold, care needs to be taken when considering these stocks (especially in the financial sector), as I believe the banks have not fully realised the extent of the sub-prime crisis.

That said based on my analysis, I expect the All Ordinaries to be trading around 6000 points by the end of this year with it likely to peak between March and May 2009.

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