This article was published on 13 March 2004. Some information may be out of date.

QOver a year ago I completed the development of a share picking software application that uses a Warren Buffett style approach to filtering out promising shares.

My philosophy was that if you could describe a repeatable technique for picking shares, then software could do this too and save you a lot of research. I know Warren does a lot more than just analytical analysis, but you have to start somewhere.

My application picked about 30 shares across the Australian and New Zealand stock exchanges, and hence my paper trading began. I paper traded the top five picks, which were all Australians shares.

What I have found is that my return on investment to date is 120 per cent (over 13.5 months), or 106 per cent annualised including exchange rate adjustments and brokerage fees. And that’s after tax on dividends (39%) and not including Australian franking, which I understand we cannot take advantage of from NZ.

Interestingly, only three of that five are still in my top five picks based on latest data.

The other shares in the list have all done very well also.

Is it really this easy or have we seen an unusual year for the share market?

I’m about to move from paper trading to an actual investment.

AWelcome to billionaire status — if you have, in fact, worked out how to pick shares. To my knowledge, it will be a world first.

I suggest, though, that if you are going to move from paper to real trading, you start out investing a fairly small amount. The last time I heard of somebody who did brilliantly on paper trading and then moved to the real thing, he wound up losing $30,000 in a year.

Warren Buffett has an extraordinarily good record at stock picking. But even he has not always performed well.

More to the point, many people have tried to replicate his success, as you have, using his methods. So far, no Buffett II has turned up.

It makes you wonder if Buffett just happens to be amazingly lucky. They say that if you get enough monkeys typing, one of them will come up with “Hamlet”. Could it be that Buffett is the best monkey?

Similarly, the man who lost $30,000 may have been the one in ten or twenty using that trading system who happened to do well while he was paper trading, by sheer luck.

In your case, given that you were trading only five shares, it’s quite feasible that you, too, have been unusually lucky.

Several readers and I have been debating, in recent columns and again today, whether you need 10, 20 or 50 shares to be well diversified. But no expert would call five shares a good spread.

On the other hand, if you just happen to pick a few of the year’s top performers, you will do superbly.

And you HAVE done. For all that 2003 was generally a good year for shares, you’ve done much better than the market. But what about next year? And the year after?

I’d be really interested to hear how you’re going in a few years.

In the meantime, all you other readers who want to get in touch with this reader, sorry, but I’m not going to act as a go-between. I’m too wary.

QI am a property investor, and in my opinion the first letter in your column last week and your response should be compulsory reading for anyone thinking of direct investment in property.

In the three years I have been reading your column, I have never heard you overstate the risks of investing in property. Bad tenants, no tenants, rising costs, rising interest rates, falling property prices, an undiversified investment — it’s all true.

Direct investment in property requires significant knowledge, time and tolerance for risk.

Compare that with investment in a share fund — little knowledge, little time and less risk (because of diversification) for similar (probably better) returns averaged over the long term.

I choose property because I find it fun — it is not easy and it is not for everybody.

So if any of your readers are wondering whether to invest in shares or property, wonder no more.

An automatic payment for as much as can be afforded (say up to 10 per cent of gross income) paid into a passive international share fund is all that is required.

No stress. No hassles. Just do it. Bet you never thought you’d see that pig fly past your window!

P.S. I know you would be disappointed if after three years of reading your column, I had only invested in property. I have not. I also have investments in shares, unit trusts and hedge funds. Thanks for your help.

AAnd thanks for your encouraging letter.

For those who missed last week’s column, a reader said “if your correspondents think that property has just had a great year,” the return on his portfolio — mainly diversified share investments in NZ and overseas — was more than 30 per cent after tax.

And the average return over eight years has been more than 10 per cent a year.

I ran the letter because many people don’t realize that shares have done as well, if not better, than property recently.

Perhaps because many people’s biggest asset is their house, the news media focus much more on what happens to house prices.

A key point in your letter is that you find property investment fun.

It does seem to suit some people, despite the drawbacks you listed. As long as the fun outweighs the drawbacks, fair enough.

It’s really important, though, that every would-be property investor understands the drawbacks. Your letter, coming from the property side of the fence, may have done more to convince them than I ever could.

QLetter from stockbroker Brent Sheather, who sometimes writes for Weekend Money:

You might be interested to know the source of the quote from me, “You need a 50 stock (minimum) portfolio to achieve the full benefits of diversification”, which one of your readers commented on last week.

The paper “Have Individual Stocks Become more Volatile?” was published in the Journal of Finance in May 2000 and was written by John Campbell (professor at Harvard), Martin Lettau (Federal Reserve Bank of New York), Burton Malkiel (Princeton University) and Yexiao Xu (University of Texas).

Coincidentally one of the authors, Burton Malkiel, is cited by your correspondent as supporting the notion in his book that only 15 stocks are needed to achieve diversity. I think it’s fair to say that this paper updates his previous work.

The Journal of Finance is up there with the Financial Analysts Journal as best of the best in the field of finance. But the article hasn’t had much publicity except for the London Financial Times and the NZ Herald — probably because it’s not the sort of news most practitioners or investors want to hear.

The authors say that individual stocks have become much more risky in the last 30 years, although overall market volatility has not increased. In other words the benefits of portfolio diversification have increased.

Up until now conventional wisdom has held that 20 or 30 stocks confer most of the benefits of diversification. However, Campbell et al show that in 1986 to 1997 investors needed 50 shares to reduce overall risk to the same level as was achieved by only 20 stocks some 25 years earlier.

This has important implications for private individuals. How many people could afford 50 different share holdings of a reasonable size, of say $5,000 each? Those with smaller holdings will have much riskier portfolios than they need to.

The authors break the volatility of an individual stock into three components: volatility attributed to the market, to the firm’s industry, and stock specific risk.

While market volatility has not increased, the proportion of total volatility represented by the riskiness of the individual firm increased from 65 per cent in 1962 to 76 per cent in 1997.

The study speculates that this increase in stock specific volatility may be due to the decline in popularity of conglomerates, the trend for companies to seek a stock exchange listing much earlier in their life-cycle, the impact of executive options and increased institutional ownership of stocks. So there you go!

Any stockbroker or financial planner will have seen numerous instances of “not-so-well funded retirements” due to overexposure to poor performing stocks or sectors of the stockmarket (tech for example).

In one case, a young girl had a serious accident, and her grandparents in 1985 put into trust for her benefit about ten NZ stocks, including a few disasters like Equiticorp but also lots of then blue chips.

This money, had it been invested properly, could have made a real difference in her life. But due to the poor performance of a few of her “blue chips”, like BIL, Fletcher Challenge and Carter Holt, almost 20 years later she is barely better off in nominal terms. Were her trustees negligent? Probably.

How many New Zealanders’ retirements have been materially impacted because one or two of the 10 stocks they owned were Fletcher Challenge and Brierley? My guess is a lot.

In many cases picking stocks is a “hit and miss” affair depending on chance or, worse still, expert advice, and occasionally on such variables as who you worked for (ie Fletcher Forests = bad, General Electric = good). Common sense tells you 10 stocks is too few.

Your reader says stockbrokers often only pick 10 stocks. This in no way validates the practice. On the contrary many financial advisors have a different view of risk from that of their elderly clients and are often happy to focus on the return part of the equation rather than the risk side.

Picking 10 stocks is more a game of chance than a reliable investment strategy. With so many low cost, tax-effective index funds around, and a good few actively traded funds too, noone any longer has an excuse not to diversify.

AYour source looks pretty solid to me, and your arguments make sense. I’m sticking with index funds too.

Your last paragraph also nicely underlines the point I made in the first answer this week.

If a portfolio of ten stocks is a game of chance, five is even more so.

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Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to [email protected] or click here. Letters should not exceed 200 words. We won’t publish your name. Please provide a (preferably daytime) phone number. Unfortunately, Mary cannot answer all questions, correspond directly with readers, or give financial advice.