My current investing goal is to outperform an ETF tracking the FTSE 100 total return over any given five year period. However, after reading some more about expected returns and the various sources of those returns I think that goal needs some adjustment.
Whilst I don’t believe the market is completely efficient, I do think that the market is efficient enough so that for most people the odds of adding value via stock picking are virtually zero. This doesn’t mean that you have to settle for the returns of the FTSE 100 or All Share indices though, or even an international mix of indices.
The CAPM Three Factor Model says that the returns from a diversified portfolio come almost exclusively from Market Risk, Size Risk and Value Risk. What constitutes a diversified portfolio is somewhat subjective, but according to Elton and Gruber’s paper "Risk Reduction and Portfolio Size: An Analytic Solution" a portfolio of 10 holdings will have about half the volatility of annual returns of a single holding. More holdings reduce volatility by an ever reducing amount. If you hold fewer companies then you are exposed to Concentration Risk, which according to the theory doesn’t have any associated return.
Instead the returns come from the market return multiplied by the percentage of stocks in your portfolio (the stock/bond split) and the weighted average beta of those stocks, the weighted average market cap and the weighted average price/book ratio (and a few extra bits about the risk free rate which I won’t go into here). The lower the average size and price/book, the higher the expected returns. Given that my benchmark is a tracker of the FTSE 100 which is full of large companies and many growth companies and that my portfolio consists exclusively of small value companies, it doesn’t seem fair to just beat that benchmark and claim myself victorious since the model says a dart throwing chimp could do the same.
As yet I don’t have figures for the UK, but there are a number of sources that have figures for the expected return from holding small value companies in the US. For example, in Mark T. Hebner’s active investor bludgeoning “Index Funds, The 12 Step Program for Active Investors” (available for free at his rather excellent site), he cites the return in the US from 1927 to 2006 from holding the smallest 30% of companies relative…
