The magnificent seven

September 21, 2012, 11:39 am Marcus Padley Yahoo!7

How a small group of massive Australia companies skews the data and possibly your trading decisions.

You may have heard of the Magnificent Seven, the biggest seven stocks in the ASX 200 index. They account for 42% of the index by market capitalisation. The Magnificent 10 account for 50% of the index and the Magnificent‘ish’ 50 account for 80% of the ASX 200 index.

In other words the Australian indices are a “Rock in a Sock”. A small group of large stocks are almost completely dominating index performance whilst a massive tail of over 2000 other “opportunities” go begging.

The net result is that since the most recent top in April last year BHP has accounted for 38% of the fall in the market on its own and BHP, RIO, Newcrest, Woodside, Fortescue and Alumina, just 6 very unmagnificent resources stocks, have between them accounted for 72% of the fall in the index and if you want to push it out a bit further just 20 stocks have accounted for 97% of the fall in the market. Looked at another way, 10% of the stocks have dictated 100% of the performance since the top of the market last year.

So before you use “the market” as an excuse for why you lost money in the last sixteen months you might ask yourself if the index actually has any relevance to what you do because the market indices in Australia are a lousy benchmark for an active self managed super fund investor or trader and an even more inequitable stick for a self managed super fund investor’s spouse or dependents to judge them by.

Anyone whose advice or performance is benchmarked to an index is compromised or compromises themselves because they end up being pressured into holding what has come to be known as the “Moron Portfolio”, a portfolio of all the biggest stocks in the market. BHP, the big four banks, Telstra, Woolworths, Wesfarmers, Woodside, RIO and Westfield because the unfortunate truth is that this small group of stocks completely dominate the calculation of the Australian indices and anyone who wants to come close to the index has to hold them or advise you to hold them. We talk about bias reducing the value of analysis and advice. Well a bias to the biggest stocks in the market destroys it, especially in a year in which the biggest of those stocks falls 34%, another 37% and another 28%.

The interesting part of all this of course is that as an average 20 stock self managed super fund portfolio investor you have no reason to benchmark themselves. Why would you? But you do. You see the index as your yardstick. But the experience is that the moment you start benchmarking yourself, even to a well distributed index let alone the “Rock in a Sock’ indices we have to put up with here, you start to pervert the stock picking process. If you fear a spouse, your dependents or even your own expectations you immediately start to do things that distort the purity of your purpose which is quite simply ‘to pick the best investment in the whole world at any particular moment in time’. To do that effectively you have to do it unencumbered by the need to picks stocks that help you perform like the index.

If you’re worrying about what someone is going to say you have already lost. Choice and freedom have gone and anxiety and stress have crept in to your detriment. It is not necessary. Let the fund managers and the people that invest with them worry about their relative performance. If you are a self managed super fund investor or trader you have a lot of advantages over fund managers. They include flexibility and speed. The ability to deal in anything at any time without the same liquidity constraints. But most of all they include operating without the pressure of clients looking over your shoulder and without having to perform relative to an assembly of big and occasionally rubbish stocks.

They can build an index, but they can never take your freedom.

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