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The risks of 'cheap' shares

04 December 2014  |  Portfolio

DangerInvestors in shares like to look for "cheap" buys. In terms of psychology, it is much the same as looking for discounts in consumer products. But there are very big differences between buying a cheap product and cheap shares. Share prices are indicators of future expectations. You are not buying a "thing", like a car or some clothes, you are buying psychology and sentiment.

This has always been the case. Since the explosion of the global derivatives markets, with many shares there is a whole level of trade above the conventional buying and selling of the securities on the exchange. That amplifies volatility and makes the role of psychology even more pronounced. Equity markets have become much more a casino than ever before -- or, more accurately, there is a massive casino above the stock market that is new.

The AFR is quoting Boston-based fund manager GMO, which looked at stocks in the US from 1970 to 2011 and analysed their risk and return trade-off. It suggests that the hunt for 'bargains' can be dangerous:

"What the manager found was the stocks that were the most volatile and the most sensitive to the market didn’t give investors the best outcomes.

Indeed, during those 41 years, the 25 per cent of US stocks with the highest sensitivity to the market delivered an average annual return of 7.2 per cent. In contrast, the 25 per cent of stocks with the lowest sensitivity to moves in the market gave investors an annual return of 10.6 per cent. The trend was more pronounced from 1984, when the safe stocks returned 10.1 per cent per annum, against 4.1 per cent for the most market-sensitive.

It wasn’t always the case. If the numbers were crunched from 1926, the riskiest stocks delivered an average return of 11.6 per cent, compared to 10.9 per cent from the safest stocks. Perhaps not much of a difference considering the risks.

One reason why is that, since 1980, retail investors have owned fewer stocks and that means professional investors have owned more and many of them are measured by an index.

That means buying some stocks they might think are expensive, but it’s too much of a bet not to own them, so they are forced to buy more, which can drive prices higher and make the stock more volatile. Also, to save on costs, index fund managers buy just enough shares to match the benchmark return without buying everything in the index. If everyone did this, the relationship between the sharemarket and shares would be out of whack, as managers aren’t buying on the back of traditional drivers like earnings and interest rates.

In 1980, individuals owned 48 per cent of stocks, but that had fallen to 22 per cent by 2007.

Furthermore, James Montier from GMO has studied annual returns over the past 25 years – a time when companies in the US have done everything to boost their share prices. On average, returns in those years have been lower than what they were in the preceding 50 years. Companies that have put shareholders ahead of everything else are also behind the decline in US business investment, increased income inequality and a drop in workers’ share of economic output, Montier said.


In the Australian market there is a heavy bias towards the high dividend paying oligopolies. In GMO's terms, they are the "expensive" stocks that you can't afford not to own. What this research does suggest is that those investors who want to look for "cheap" buys should strongly diversify, perhaps even consider indexes in the higher risk sectors. Taking more risks does not necessarily mean you will eventually get higher rewards.


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