Seven years ago, shareholders in Netflix – the S&P 500 listed provider of online movies and shows – suffered a crushing loss as it disastrously attempted to raise prices and restructure.
Roughly one million customers cancelled their subscriptions.
Netflix’s share price plummeted to less than $53 from $300 in a matter of weeks, a loss of 83 per cent.
During this tumultuous period, billionaire investor Carl Icahn – a legend in investment circles – did not even initially have Netflix on his radar. However, he was convinced by his son, Brett, to take a position in the disruptive company against all the odds and the slew of investors dumping the stock. He eventually took a 10 per cent stake in the company.
Brett’s instinct was right. Netflix cast aside its flawed strategy, and painstakingly started to rebuild its brand and customer relationships.
The following year, Icahn sold half of his stake in the company at multiples of his purchase price, reaping a staggering profit of $825m – any investor would be pleased.
However, Brett believed that the company was undervalued still. Nonetheless, Icahn was not to be moved: the following year, he sold the rest of his position, profiting to the tune of about $2bn.
While it is hard to call a $2bn profit a mistake, it has likely caused some frosty moments at the Icahn family holidays; with the benefit of hindsight, we know that Netflix has continued to grow and expand even beyond Brett’s expectations.
Had Icahn held his original position of around 5.5m shares, his profit would have been $13.9bn.
Despite the huge gain from the Netflix investment, the holding formed less than two per cent of the fund’s holdings, which had larger positions at the time in Ebay, Federal-Mogul, Hertz, Chesapeake Energy, Nuance Communications and American Railcar; these summed up to 25 per cent of the fund.
Most of these performed poorly in that year. Therefore, in spite of the windfall gains from Netflix, the fund posted a loss of seven per cent in 2014, compared to a 14 per cent total return for the S&P 500.
Icahn is considered a master of picking the right investments, and indeed, his track record is among the best. However, as the above illustrates, picking the right stocks is difficult – and often winners occur by chance, while losses come despite overwhelming analysis, due-diligence and conviction.
Even more precarious is timing the optimum entry and exit point, as the above example shows.
Indeed, while security selection decisions are important, larger asset allocation decisions are always more important.
United we fall
To illustrate why, take the 2018 returns among the FTSE 100 constituents. The top 10 performing stocks returned 32 per cent on average, while the bottom 10 lost 40 per cent. Intuitively, one can surmise that with such dispersion, picking the right securities is the way to go.
But most investors would never hold as few as 10 securities. The concentration risk – or lack of diversity – would be too high. In fact, most research states that a minimum of 30 stocks is required to maximise a portfolio’s diversification benefits.
However, even a portfolio of 30 stocks, selected from the FTSE 100 at random, would likely result in returns closer to that of the index itself.
Trying to pick the winners, as Icahn does, can add more risk. Furthermore, since stocks tend to be quite correlated in bear markets (because there tends to be indiscriminate selling), even holding 30 stocks offers little diversification benefits.
For example, in 2008, only 10 companies in the FTSE 100 delivered a positive return.
This correlation effect is largely isolated to securities within an asset class. Stocks tend to rise and fall together, as do bonds, as do real estate holdings.
But the correlation between asset classes tends to be far less, and even negatively correlated at times. In other words, when one moves up, the other could move down. And therein lays the crux of why asset allocation matters more.
Dr Raghavendra Rau, a finance professor at Cambridge, following on from the logic above, proved that asset allocation is more important than security selection on an empirical basis.
Conducting a rigorous simulation exercise using 21-years of data between January 1991 and December 2011, he showed that the average monthly difference between portfolios that allocate assets well (that is, the top five per cent) versus those that do it poorly (the bottom five per cent) is two per cent.
On the other hand, the difference between good and bad security selection is two per cent each month.
More importantly, at times of genuine geopolitical or financial stress – when the risk of losing money is at its highest – the importance of asset allocation soars. During the first Gulf War in February 1991, the Asian crisis in August 1998, the dotcom crash of March 2000, and the crash of Lehman Brothers in September 2008, the monthly difference between portfolios that allocated assets well versus those that did it poorly was 6 per cent, 5.5 per cent, 4.8 per cent and 5.4 per cent, respectively.
The difference due to security selection stayed stable around its long-term average of 1.5 per cent, regardless of market conditions.
The key here is that both asset allocation and security selection are important and both must be done well, but getting asset allocation right is far more important, particularly at times of great market stress.