Tuesday, July 25, 2006

Market beating returns or just coincidence

Chris Dillow points out that low risk stocks beat market returns over time. I think he is making a mistake by drawing this conclusion based on the performance of a 20 stock portfolio versus the 350 stock FTSE 350 index.
I remember some analysis quoted in Robert Hagstorm's book on Buffett where he found that there is a higher probability of beating the market with a fewer number of stocks - implying that if you randomly put together 20 stock portfolios based on arbitrary criteria, a higher number of them would outperform the market than a similar collection of portfolios based on 100 stocks each for example. Of course the returns would be more volatile but the point is that just because a portofolio of 20 stocks picked according to some criteria outperforms the market doesn't necessarily mean that there is there is any correlation with the criteria. It could simply be increased reward for the higher risk of a smaller number of stocks. It is quite possible that a collection of 25 stocks starting with the letter 'A' also outperforms the market.This may not totally go against what he's suggesting but it seems that you need to show more data to make the argument. I know that 15 stocks diversify away something like 80% of non market risk but that is an average figure. Hagstorm's numbers still show the increased probability of beating the market with fewer stocks in a portfolio.
Update - Chris acknowledges that random portfolios can outperform the market but goes on re-iterate that the defensive anamoly ( as he puts it ) lasts much longer. Fair enough I suppose.

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