Small and speedy only wins sometimes

Q. The NZSE top 40 is now the NZSE top 50.

Apparently the former had a dismal performance, but if you added the next 10 and made it the top 50 the result was much better.

So what does that tell me? Why not invest in the top 41 to 50, reap the rewards and don't prop up the aforementioned 40 by diluting your returns?

What, in your opinion, is the flaw, if any, in my thoughts on this matter?

A. If only it were that easy.

But it never is in the sharemarket. If somebody did discover that any particular type of shares - in this case smaller companies - was a better bet than other shares after taking risk into account, everybody would want to buy the superior ones.

The demand would push up their prices until they were no longer a better buy.

But let's take a step or two back.

If we look at a graph of the NZSE40 capital index, the one most often quoted, and the new NZSE50 (calculated back a few years to show where it would have been if it had existed), the NZSE50 does perform better.

But the two indexes differ in several ways other than the number of shares included.

The top 50 index includes dividends and an allowance for dividend imputation. That, in itself, will make it strongly outperform the NZSE40 capital index.

Also, the top 40 index ranks companies based on "absolute market capitalisation", which means the value of all shares. The NZSE50 uses "free float market capitalisation", which means the value of shares that are freely available for trading.

That won't necessarily make the 50 perform better or worse than the 40, but it will make it perform differently.

The point is that you're comparing lettuces and cabbages (just for a change!). You can't conclude that the reason the NZSE50 has done better is the inclusion of those extra 10 companies.

Having said all that, if there were directly comparable indexes, the top 50 would, indeed, have performed slightly better than the top 40 over recent years.

Only slightly, mind. All these indexes are weighted, so that big-company share movements have much more effect than small-company movements. Any weighted top 50 index will be hugely dominated by what happens to its biggest 40 shares.

Still, over the past 10 years - unfortunately, I couldn't get longer-term data - smaller New Zealand companies have performed better than bigger ones.

From mid-March 1993 to now, the average return, including dividends, of the NZSE10 has been 7.7 per cent a year, and for the NZSE40 it has been 8.2 per cent. For the small companies index it has been a healthy 12.1 per cent.

The difference has been even bigger over the past five years, but that's too short a period to judge share performance.

The small companies' superiority is partly because they tend to be higher-risk.

Higher risk means higher average returns - but more chance of coming a cropper, especially if you invest in only a few companies or for just a short time.

There have certainly been periods of a year or two when large New Zealand shares have clearly outperformed smaller ones.

In the US, this happened for a whole decade, 1987 to 97. There's no guarantee the same thing won't happen here.

You might feel a little ill if you're sitting in your 41st to 50th biggest companies, making an average of, say, 2 per cent a year for several years while the big companies are returning 8 or 9 per cent.

I'm not trying to put you off the littlies. It's a great idea to invest not only in big companies but also the smaller ones - either directly or via a share fund.

But if you concentrate only on the small companies, you're taking a fair bit of risk.

As economist Milton Friedman said about investment, "There's no such thing as a free lunch".

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Q. We are a retired couple in our seventies. We own a mortgage-free home, which we recently had painted, new carpets laid and roof recoated. We have renewed our fridge, washing machine and TV and we also have a near-new motor car.

Our cash assets are: $40,000 in Kiwi Bonds returning 5.25 per cent; $40,000 in Bonus Bonds returning about $100 a month; $50,000 in bank term deposits at 5.6 per cent; $67,000 in a savings account at 5.0 per cent; and $74,000 in a cheque account at 4.5 per cent.

We do not have any credit cards and all our purchases are cash. Our net weekly income is approximately $700.

We normally holiday twice a year in Australia and do not wish to go further afield.

We have never been left anything, and all our cash has been through saving all our working life and after. We have no debts.

Our two children, both married and living overseas, need no assistance from us.

We are not interested in any long-term investments such as shares etc.

We would be interested in your comments or suggestions on our situation.

A. At first glance you seem to be sitting fairly pretty, if conservatively.

A couple of quibbles:

* You have too much in savings and cheque accounts. Surely you don't need more than $10,000 or $20,000 at call. The rest could be earning more interest in term deposits.

* The return on your Bonus Bonds is only around 3 per cent. That money might also be better in term deposits. On the other hand, you probably enjoy the gamble of Bonus Bonds. And who knows, one day you might win big.

I'm not sure where the $700 net weekly income comes from. It seems to be more than your interest plus NZ Super.

But, assuming it's correct, it seems likely to cover your outgoings.

There's one big worry, though, and that is inflation. While it's much lower these days than in the 70s and 80s, it's still there.

You two might live a further 20 years or more. If your interest income stays the same, after 20 years of inflation at around 2 per cent a year your buying power will have dropped by about a third.

And if inflation should run at 4 per cent a year, your buying power will be considerably less than half of what it is today.

OK, you might be saying, but:

* "Won't our interest income increase if inflation increases?"

It's true that interest rates tend to rise with inflation. But the link's not all that strong. These days, the gap between the two is larger than it was over the past few decades. It would be dangerous to assume that, if inflation rises, interest will go up to compensate.

* "We expect to spend less as we grow older." Fair enough. But medical and related bills might rise.

* "We can always start using up our principal." Yes, but at what pace? If you live longer than you expect, you might run out of money.

Given that you're fairly comfortably off now, it would be a pity to find yourself financially insecure in your old age.

So what can you do about it, without going into riskier investments to boost your returns?

If you're currently spending less than your income, you could just systematically reinvest about half of your interest.

But if you're spending most of what you get, you could look at an annuity. You pay an insurance company a lump sum and it gives you monthly payments for life.

The return is higher than on term deposits. The company is, in effect, giving you back not just interest but also your principal.

And you can set it up so the payments increase by a set amount each year, perhaps 2 or 3 per cent, to allow for inflation.

The example I gave in this column on February 1 is relevant to you.

The couple, both aged 78, could get a return starting at about 8.67 per cent. And the insurance company has already paid tax on that, so they would pay no more tax.

The amount would increase by 2 per cent a year, so in the second year it would be 8.84 per cent, in the third year 9.02 per cent, and so on.

Payments would continue for the first five years, even if they both died in that time, with the money going to their estate. After that, payments would drop by a third when the first one died.

If you are younger than 78, the payments would be somewhat lower. But an annuity could still suit you well.

Ask an insurance broker to get some quotes for you.

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Q. I am a small investor, now aged 67 years. After reading recent letters to your column, I have been stirred to support the cause of equity investment.

Although I have invested in the markets for some 40 years in both equities and unit trusts, my present $75,000 portfolio of equities has been largely built over the past five years. I have now achieved the aim of another income stream in retirement, with modest income and capital growth forecast.

This investment is allocated between nine NZ public companies, with individual investments ranging between 5 per cent and 20 per cent of the portfolio.

I do not trade shares to lock in capital gains, and only sell if I think the company has a problem with future profitability.

Equity investment is a simple process, with scripless trading and various share-registry services available at minimal or no cost to investors. Dividends can be directly credited to a bank account.

Internet sites such as the Herald's Stockwatch provide a facility to quickly check the state of play of the portfolio. Hardly an overwhelming exercise.

My broker's fees are 1.5 per cent, and I can access a wealth of free research and analysis.

Funds may work OK for those with sufficient discretionary income throughout a working life to make regular investments, but they require blind faith that the overall market will be profitable over time, or that fund managers will make better decisions.

I am more comfortable knowing where my money is at risk, and can react accordingly. I abandoned unit trusts many years ago, and that was a right decision for me.

A. You sound happy with what you've set up. That's important.

And your diversification is not too bad. Many New Zealanders hold a lot fewer than nine shares. I also like your buy-and-hold strategy.

If I can be blunt, though, I think you and many others who run their own portfolio of shares may feel more in control than you really are.

Sure, you know where your money is, and can react to news about the companies in which you are invested.

But, as an individual investor, you're not usually going to hear the news until hours after the big financial institutions have acted on it. So the information isn't a lot of good to you.

If, for instance, a company announces a big new contract, by the time you hear it and buy the shares, the institutions will have made their purchases.

That extra demand will have pushed up the price to the point where it's not a particularly good buy.

The same with bad news. When you sell because a "company has a problem with future profitability", I doubt if you get a good price.

The above assumes the New Zealand share market is "efficient", with share prices reflecting available information.

Some people argue that it's not efficient, especially for shares in companies that are too small for the institutions to bother with.

Even then, though, are you likely to be among the first individuals to act on new info?

To a considerable extent, every share investor is at the mercy of market forces.

That's one reason some people prefer to invest in rental property.

Each property - as opposed to each share in a given company - is unique. You might be the only one interested in it.

Bargain properties are there for those who do their research and are lucky. But I've yet to be convinced that the ordinary investor can identify bargain shares, even after doing lots of homework.

I don't even think full-time fund managers are all that good at it, which is why I recommend index funds, which don't bother with share selection.

* Mary Holm is a freelance journalist and author of Investing Made Simple.

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