Our Insights

About personal finance, investments and markets.
September 21, 2015

Lessons from VW crash after emission cheat

VW’s share price dropped by ca. 20%* today on the back of reports that the company has manipulated emission tests. The news has not only hurt its market-cap to the tune of >€15bn, it will also hurt its brand image and probably lead to massive fines and class-action lawsuits. What are the lessons for investors? (1) Private investors should not buy individual stocks and (2) some indices like the DAX are poorly diversified, making them bad choices for long-term investors.

Individual stocks are riskier than most believe

Every year S&P Dow Jones Indices publishes their annual findings whether active fund manager beat their benchmark with the same predictably sad result: over 5- and 10-year periods, typically more than 80% of funds fail to deliver incremental returns over the benchmark (**). Worse, even star investors like Warren Buffett are increasingly struggling to beat the equity markets (link). So if professional investors can’t win, what are the chances that private investors are better than the pros?

Most likely private investors who try their hand at picking individual stocks will be shocked at the conclusions reached in a study (***) covering a period of 14 years and looking at 3000 stocks:

  • 39% of stocks lost money during the period
  • 19% of stocks lost at least 75% of their value
  • 64% of stocks underperformed the index
  • The average annualized return was -1%
  • BUT: the average annual return of the equity market during that period was 8%!

Readers may be wondering how it is possible that the equity market was rising by 8% p.a. while the average stock had a negative return of -1% p.a. The answer is mostly a function of the index construction methodology. Most indices are market capitalization weighted. This means that successful companies (rising stock prices) receive larger weightings in the index. Likewise, unsuccessful companies (declining stock prices) receive smaller weightings. Which individual investor is able to structure his portfolio accordingly? Investors make a serious mistake when they take idiosyncratic, diversifiable and uncompensated risks. They mainly do this because they are overconfident in their skills – don’t make the same mistake.

Not all indices are created equal – avoid excessive concentration

Most investors prefer to invest in their home market (home bias). This is also evident in Germany (****) where the top 3 index funds are all ETFs on the DAX. However, the German equity index DAX suffers from serious short-comings: it invests only in 30 companies. This is categorically not enough to diversify idiosyncratic risk away. The same is true for many other European Indices like the CAC-40 (France, 40 stocks) or AEX (Netherlands, 25 stocks). Investors should choose indices that comprise more than 100, ideally at least 500 stocks. If one company fails or one sector struggles, this should not unduly affect the overall investment. Long-term private investors should not be over-exposed to any given company, sector or country. The Volkswagen scandal is such a great argument against excessive concentration.

The Volkswagen crash today is a case in point: VW accounted for 4% of the DAX and the automotive sector for nearly 20% (pre cheating announcement). VW’s drubbing thus affected the DAX index materially. While the German car manufacturing sector is still world-class, the same could have been said about the German consumer electrics sector some 20 years ago. Anyone remembers Grundig? Nokia? Kodak?

 

* To put this into perspective: VW’s share price currently -20% and CDS +70 post EPA notice. However, 2 months after the Deepwater Horizon spill, BP’s stock was down 45% and the CDS +500 wider. There is a significant risk that VW’s share price comes under more pressure.

** http://www.spindices.com/documents/spiva/spiva-us-year-end-2014.pdf

*** http://gallery.mailchimp.com/6750faf5c6091bc898da154ff/files/The_Capitalism_Distribution_12.12.12_1_.pdf

**** http://www.faz.net/aktuell/finanzen/aktien/arno-walter-im-interview-ueber-deutsche-und-aktien-13709305.html

Please read our Terms of Use.