Diversity an investor’s best friend

One of the most important insights about investing is that you are only one of a multitude of people trying to do well.

You may be smart but are you astute enough to recognize an opportunity far enough in advance to actually do something about it? Trying to pick investments that are superior is a daunting task and every study shows that humility is a good addition to an investment strategy.

To illustrate, hark back to New Year’s Day 2012. In addition to overdosing on televised college football, you spend part of the holiday working on the family finances. Armed with a laptop and various online financial tools, you’re on the hunt for appealing stock market opportunities.

To prune the list of candidates to a manageable size, you decide to focus on firms that are leaders in their respective industries and exhibit above-average scores on various measures of financial strength. As you work your way through the alphabet, you come to the “P” stocks, and another candidate appears. It’s a prominent player in a major industry (good), but operates in a notoriously cyclical industry (not so good), is currently losing money (definitely not good), pays no dividend, and has a junk-bond credit rating of BB-minus.

Next! You push the “delete” key and move on.

Congratulations. You just passed up the best-performing stock in the entire S&P 500 Index for 2012.

Shares of PulteGroup Inc., a Michigan-based homebuilder with a 60-year history, jumped 187.8 percent last year amid strong performance for the entire industry. For the year ending Dec. 31, 2012, all 13 homebuilding firms listed on the New York Stock Exchange outperformed the S&P 500 Index by a wide margin, with total returns ranging from 34.1 percent for NVR, Inc. to 382.8 percent for Hovnanian Enterprises, Inc. The Standard & Poor’s SuperComposite Homebuilding Sub-Index rose 84.1 percent in 2012 compared to 13.4 percent for the S&P 500 Index.

The point? For those seeking to outperform the market through stock selection, underweighting the market’s biggest winners can be just as painful as overweighting the biggest losers. Investors are often caught flat-footed by stocks that do much better or much worse than the broad market, and the problem is not limited to individuals.

Not one of the 10 seasoned professionals participating in Barron’s annual Roundtable stock-picking panel in early January 2012 mentioned homebuilding stocks or any housing-related firms.

The recent surge in housing shares also serves as a reminder that stock prices are forward-looking and tend to rise or fall well in advance of clear changes in company fundamentals.

Investors who insist on waiting for evidence of healthy profits before investing are often frustrated to find that a firm’s stock price has appreciated dramatically by the time the firm begins to report cheery financial results. Shares of Hovnanian Enterprises, for example, rose 580 percent between Oct. 7, 2011, and Dec. 31, 2012, even though it continued to report losses. Similarly, it is not unusual for a firm’s stock price to decline long before signs of trouble become obvious.

The behavior of the S&P Homebuilding Sub-Index in recent years illustrates the challenge of relying on industry characteristics to provide a reliable guide to the direction of stock prices. Many observers in recent years predicted that a recovery in the housing industry would be agonizingly slow, and they were right. Many investors in recent years have avoided housing stocks as a consequence, and they’ve been wrong: Housing stocks have outperformed the broad U.S. stock market by a healthy margin from the market low in March 2009 to the present day.

The lesson: Markets have 101 ways to remind us of Nobel laureate Merton Miller’s observation that diversification is the investor’s best friend.

Mark Sievers, president of Epsilon Financial Group, is a certified financial planner with a master’s in business administration from UC Berkeley. Contact him at mark@wealthmatters.com.