Diversification the Right Way- Part II
Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Yesterday I wrote a piece on diversification, not by sector, but by the stock's previous calendar year return. I suggested that by investing in a four stock portfolio comprised of the two best performing S&P 500 stocks and the two worst performing stocks from the previous calendar year, and holding them for one year, that you could do better than the S&P 500. Employing such a strategy over the last three years would have resulted in a 131% 3-year cumulative return versus 48% for the S&P 500. Those results are quite staggering and I wanted to do a more in-depth look at the strategy and see how it fared in other years and down markets, especially.
I will recap the names that are to be purchased for 2012 using this strategy. The S&P 500's biggest constituent loser in 2011 was First Solar (NASDAQ: FSLR),which lost 74% in 2011. Second was Monster Worldwide (NYSE: MWW) which lost investors 66%. The two winners were Cabot Oil and Gas (NYSE: COG) and El Paso (UNKNOWN: EP.DL), which returned 301% and 93%, respectively. My recommendation was to buy those four stocks at the start of the year and walk away until January of next year. Below I highlight the results from a deeper look at the data.
Using this strategy since 2000 would have yielded ownership in a couple stocks that went bankrupt, or were saved by a buyer at a measly price; Countrywide Financial, Winn-Dixie, and Dana Corp. You would have been an owner of Apple (NASDAQ: AAPL) for two of those years. Many of the stocks ultimately were NOT good buy and hold names, but performed admirably for the desired one year holding period.
As you can see in the table below, the strategy was a complete bust at the start of the decade. Negative returns in the S&P 500 was magnified by the four stock portfolio. On the flipside, positive years in the Index were again magnified by this strategy, with 2006 being the exception. All told, the four stock portfolio did not perform well as a strategy to be employed year after year. It couldn't overcome significant declines in any given year, let alone three in a row at the start of the millennium.
However, if you have a strong conviction in this being an up year for the market, then this strategy is a way to leverage that bet and will likely yield market beating returns. Alternatively, you could you this method as the aggressive side of a barbell and hold U.S. Treasury bonds as a counterweight.
|
Year |
S&P 500 return |
4 stock Equal-weighted return |
Best Stock |
Worst Stock |
|
2000 |
-9.10% |
-66.72% |
-53.34% |
-78.65% |
|
2001 |
-11.89% |
-27.57% |
-3.07% |
-54.20% |
|
2002 |
-22.10% |
-25.03% |
82.82% |
-82.80% |
|
2003 |
28.68% |
170.22% |
265.92% |
72.91% |
|
2004 |
10.88% |
18.36% |
66.89% |
-54.02% |
|
2005 |
4.91% |
23.47% |
123.26% |
-31.47% |
|
2006 |
15.79% |
-20.72% |
18.01% |
-80.64% |
|
2007 |
5.49% |
16.42% |
80.01% |
-11.66% |
|
2008 |
-37.00% |
-57.21% |
-44.65% |
-67.61% |
|
2009 |
26.47% |
42.10% |
101.30% |
3.04% |
|
2010 |
15.06% |
40.70% |
89.47% |
21.50% |
|
2011 |
2.11% |
15.80% |
43.24% |
-18.88% |
| S&P 500 Return | 4 Stock Portfolio Return | |||
| Total return 2000-2011 | 6.79% | -34.75% | ||
| Total return 2003-2011 | 71.15% | 261.09% |
I have no ownership position in the referenced securities.
