So you want to beat the index

This is a follow up to the Mr. Market and Charles Munger posts.

Long term outperformance against the index is rare. Based on this smh report, it says that 2/3 of all active Australian fund managers fail to outperform their benchmarks over a 3 year and 5 year time horizon. Another thing that is also rarely mentioned in the industry is risk adjusted returns. Returns alone do not tell the full picture. It is also important to understand how much risk was taken to make those returns. Even when risk adjusted returns are mentioned, it is usually based on statistical measures of risk such as volatility (i.e. sharp ratios). Volatility as a measure of risk is a flawed concept but that story is for another time.

I believe risk can only be qualitatively assessed by understanding 1) whether there was an adequate margin of safety in the price paid for the shares, 2) whether the company’s future can be forecast with a reasonable degree of confidence.

With the above in mind, I made an investment eight years ago which has beaten the index (ASX 200 accumulation index) by more than 4% p.a. I didn’t realise it had beaten the index by more than 56% until I actually sat down and did the calculations, so I thought I better write about it to remind myself that it is possible to:

  1. Beat the index with very low risk. Risk was very low given the entry price and the quality of the business.
  2. Beat the index with only one trade. I didn’t trade in and out of positions over the holding period, it has been a simple buy and hold strategy.
  3. Beat the index without diversifying the portfolio; you can do it easily with one single stock. For this trade, I feel that diversification would not have lowered the risks but quite likely lowered the returns.

I bought the ASX after it fell from $60 to $30 in October 2008 during the GFC. This chart shows the total returns for the ASX (11.4% compounded p.a.) as compared to the ASX 200 accumulation index (7.3% compounded p.a.) over this period.

I think this was a safe and easy trade. If you took a long term view, you could quite quickly reach the conclusion that a bet on the ASX would be a rather safe bet even in the height of the GFC. Firstly, the ASX has a near monopoly on stock market trading which is protected by regulation and secondly, capital raising and trading activities will continue to grow as a result of the growing superannuation asset class in Australia which will continue to drive earnings higher.

So although far from the highest return trade you could have done during the GFC, from a risk adjusted return perspective, I think this trade ranks pretty high (better than betting on the banks at that time in my opinion). But more importantly, you could have the confidence to bet the farm on something like this and if you did, you’d increased your wealth by 150% with taking very little actual risk.

Any feedback or comment much appreciated.


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