Stock investing: Diversify sectors, countries

(Moneywatch) As we've seen this week, investors purchasing individual stocks are speculating by taking uncompensated risk. They're basically operating under the assumption that the market has mispriced the stocks they're purchasing. Purchasing a sector (single industry) fund is making a similar, though not quite as bad, mistake.

Investors buying sector funds are assuming that somehow the market has mispriced not just single (or a small group of) stocks, but an entire sector. There's no logical reason or any evidence to suggest that the market either misprices entire sectors or that investors can profit from any such mispricing. My book, "The Quest for Alpha," presents the evidence and the persistent failure of professionals and individuals alike to exploit any such anomalies.

The reason that investing in sector funds isn't as serious a mistake as investing in individual stocks is that at least you have reduced the idiosyncratic (and thus uncompensated) risks of individual stocks. However, you're taking the idiosyncratic risks of a sector, risks that can clearly be diversified away by owning broad market indexes or entire asset classes -- which is why it's still a mistake as you don't get compensated for diversifiable risks.

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A similar mistake is investing in single country funds (with the exception of a total U.S. market fund). While not as bad a mistake as investing in individual stocks and/or sector funds (because you have diversified away the idiosyncratic risks of the individual companies and sectors in the country), once again doing so means taking the idiosyncratic political and economic risks of a single country -- risks that can clearly be diversified away. Thus, you receive no compensation for taking them. And again, investors in country funds are assuming that the market has somehow mispriced the stocks of an entire country. There simply is no evidence that investors are able to exploit any such mispricings (if they exist).

One reason investors make the mistake of buying country funds (besides confusing information with wisdom), is that they believe a country's growth rate is related to its stock returns. Unfortunately for them, the evidence is that while there's a correlation, it's negative, not positive. For example, a study by professor Jeremy Siegel of The Wharton School of the University of Pennsylvania found that the correlation between stock returns and GDP growth was -0.32 for 17 developed countries and -0.03 for 18 emerging markets countries.

Perhaps the most extensive study done on the subject, based on decades of data from 53 countries, found that economies with the highest growth produce the lowest stock returns. Stocks in countries with the highest economic growth earned an annual average return of 6 percent; those in the slowest-growing nations gained an average of 12 percent.

Investors are rewarded with higher expected returns (risk premiums) for taking systematic risks, risks which can't be diversified away. With stocks, there are three types of risk:

• Beta (exposure to the overall stock market)
• Size (exposure to small-cap stocks)
• Value (exposure to stocks with high book-to-market or low P/E ratios)

The academic research makes clear that the majority of a portfolio's returns are determined by its exposure to these risk factors.

Investors make mistakes when they take idiosyncratic, diversifiable, uncompensated risks. They do so because:

• They are overconfident of their skills
• They overestimate the worth of their information
• They confuse the familiar with the safe
• They have the illusion of being in control
• They don't understand how many individual stocks are needed to effectively reduce diversifiable risks
• They believe high growth rates are associated with high investment returns
• They don't understand the difference between compensated and uncompensated risks -- why some risks are uncompensated (because they are diversifiable)

If you've made any of these mistakes, you should to what all smart people do -- once they have learned that a behavior is a mistake, they correct their behavior.