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Equity Portfolios: Investment Styles

The success or failure of traditional equity investment strategies is measured by comparing performance against the returns achieved by the entire market (as revealed by a stock index).

As we saw in the previous section, a fully-diversified portfolio (representative of the spread of market industries) will typically achieve the average market rate of return. It will track the index. And even if the portfolio is not representative of the exact market composition, if it has a wide spread of investments in around 25 + shares across the market, it will roughly follow the index. Full diversification (naively done or achieved by precision index-tracking) does not look for relative long term outperformance. As a consequence, it does not risk underperformance.

A portfolio which is like the market will share in its fortunes. So, in absolute terms, it will have good years and bad years (relative to a long term average trend). And over the longer term, it will capture that trend; which, as we saw in 'Asset Allocation', is almost always positive in real terms and almost always higher than any other asset class.

When a portfolio is not fully diversified, its returns will vary from the market average over both the short and the long term.

This type of portfolio is looking to outperform the market. It is looking for higher returns ... so it must take on higher risks ... so it must take on a higher than average amount of volatility.

This means that across most short-term periods, portfolio value will fluctuate by a greater extent than the market (here represented by the S&P 500) – sometimes outperforming, sometimes underperforming.

In traditional investment terms, this short-term volatility is inseparable from the goal of seeking to outperform the market. But that performance can only be judged after a few years when the portfolio's trend becomes visible against the market's trend. After a few years, the extra risk of the more volatile portfolio should result in higher than average long term returns. If it has not, the investment style has failed.


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