Good reads from around the Web.

A common dilemma as a stock picker is the decision on whether to buy a big established firm or instead the hordes of new entrants looking to unseat it.

Typically a value investor will buy the biggie and pour scorn on the little guys and their bold ambitions.

However that isn’t always the right thing to do, as an interesting piece by Meb Faber pointed out this week.

Meb recalled that back in 2000, a question doing the rounds in his circle was whether it was better own US drugs giant Pfizer or instead buy all the equivalently valued biotech market, which was full of companies seeking to displace it.

A lot of time has passed since then, so he decided to find out the answer.

The next 15 years started with a stock market crash, which as you’d expect walloped the biotech index for six, with huge declines from its March 2000 peak.

Over the same period Pfizer was merely flat.

Yet the race was not yet won – and over the next 12 or so years of recovery, biotechs roared back.

In fact, the index is now up 1,300% from its lows.

In contrast, big old Pfizer has advanced a mere 50%.

Buying the biotechs would have been far better for your financial health.

Now, I am not sure if these graphs include dividends, which would make a difference for Pfizer.

Also I’d argue it’d be more consistent – if less dramatic – to plot both graphs from the year 2000, rather than off the lows.

Neither of those observations would probably change the thrust though, which is that the biotech index proved the winning investment.

For his part, Meb points out that some of this under-performance is just down to the sheer size of Pfizer – elephants don’t jump, and all that.

I’d add too that Pfizer wasn’t actually cheap in 2000. We easily forget that drugs companies were go-go stocks back then, with the likes of UK mega-drug corps GlaxoSmithKline and AstraZeneca also sporting racy valuations.

Pfizer was on a P/E of 60 some 15 years ago, versus just 24 today.

On a related note, I suspect biotech is now in a bubble.

Time will tell as always, but writing in The Telegraph, fund manager Terry Smith certainly doesn’t like the odds of picking winners in the sector.

Still, it’s an interesting turn of events to think about as an active investor – especially as Meb goes on to ask the same question of Facebook and the “unicorns” today. (I currently own some Facebook shares…)

Passively persuasion to bet small

Passive investors might treat all this academically.

Personally though, I’d see it as another reason to make sure I had a clearly defined dollop of small cap exposure in my diversified portfolio.

The UK market, for instance, is dominated by a handful of huge Pfizer-like incumbents.

Adding small cap shares to portfolios has previously boosted returns and I’d bet on that happening again over the long-term.

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Many private investors struggle to get their heads around the concept of asset allocation, but it is the cornerstone of sensible investment.

One idea, courtesy of The Oblivious Investor, is to think of asset allocation in a similar way to the food pyramid that many of us learned at school.

The key here is that as a long-term investor you want to own more of the assets at the bottom of the pyramid and fewer of those at the top.

Specific percentages will depend on your age and risk tolerance.

For example:

• A young investor should have substantial long-term exposure to equities.

• A retired investor living off their income would typically have shifted a big chunk of their equity funds into cash, bonds, and even (whisper it!) annuities.

All very sensible, although if I could afford a Monet I’d be tempted to head to the top of the pyramid early.

Waterlillies are so much prettier to look at than the dealing screens of online brokers.

Be roughly right

Rules of thumb such as this pyramid are useful to get past the decision paralysis that can plague new investors.

It also helps to remember that the perfect asset allocation doesn’t exist. Asset allocation is as much art as science.

Even Nobel Prize-winning Harry Markowitz didn’t bother working out his own theoretically perfect portfolio, saying:

“I should have computed the historical co-variances of the asset classes and drawn an efficient frontier.”

But, he said, “I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it.

So I split my contributions 50/50 between stocks and bonds.”

Markowitz’ focus on his tolerance for loss is also something for new investors to learn from.

If your equity allocation is above what your risk tolerance can handle in a stock market crash then you’re potentially heading for the rocks.

Selling out at the bottom of a bear market because you want to stop the pain could leave you stuck shopping at the Tesco Value baked beans end of the food pyramid in your old age.

Fine to go there when saving money for your financial freedom – but ideally you want to be able to get reckless in Waitrose once in a while when you retire!

Good reads from around the Web.

When engaged in the Fool’s Errand of active investing, one must always think relatively:

• Yes, the Eurozone looks troubled but it’s doing so much better relative to a few years ago.

• Yes, auto sales are very low in Italy, say, but more importantly they’re relatively low compared to the long-run average, so they should eventually mean revert.

• Yes some share looks expensive, but it’s relatively cheaper than the market.

… and so on.

As for passive investing, its appeal is founded on a principle of relativity. By aiming to get just the market return – minus the lowest possible costs – you’ll very likely do relatively better than most active investors who aim to beat the market but who pay a high price for trying to.

Combining these two lines of thinking is an article over at Morningstar about John Bogle’s concept of ‘relative predictability’ .

The author John Rekenthaler argues it’s Jack ‘Father Of The Index Fund’ Bogle’s least appreciated insight:

Relative predictability – a phrase that Bogle mentioned in passing to me, in a conversation last week – is something altogether different.

The relatively predictable asset is the asset that behaves as expected, given the performance of the financial markets.

Relative predictability has nothing to do with the usual statistics that measure absolute levels of risk. It cannot be measured by standard deviation.

Relative predictability is unrelated to volatility.

In its realm, cash can be highly risky and stocks can be fully safe.

Read on to discover its applications. The concept is a wonderful piece of investing philosophy that had me screaming “Yes! Yes! Genius!” as it cleared up a few fuzzy notions that I’ve been obsessing over for years.

Although if you get out more and have a rich home life, your mileage may vary…

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