What’s Working for Investors in 2011

This has been a rough year for investors. Stocks, as measured by the S&P 500,
are down nearly 8% for the year and down 14% from the April highs. And while 14%
might not sound like all that much in the grand scheme of things, investors felt
every point in a surge of volatility that brought back discomforting memories of
the 2008 meltdown in which the major stock indices lost half their value. Still,
some market sectors fared better than others. Let's take a look at the chart
below: Three sectors are in the black year to date utilities, consumer staples
and health care. (Note: these figures do not include dividends.) Consumer
discretionaries, technology and telecom are down for the year, though less than
the broader market. After that, it gets ugly. Energy and industrials are down
10% and 14%, respectively, but the real losers for the year have been materials
and financials down 18% and 23%, respectively. Investors who underweighted the
highly cyclical sectors and focused instead on the less-sexy, dividend-paying
value plays haven't had a bad year. But what is remarkable about this year's
correction is that so few investors seemed to see it coming, and this included
high-profile professionals. John Paulson, the hero of 2008 who used the subprime
mortgage meltdown to make the most successful trade in history, has had an
abysmal year. Due primarily to his overweighting to financials and materials
the two worst-performing sectors by a wide margin Paulson's flagship fund was
down by as much as 40% this year. (See John Paulson's portfolio holdings here
.) And during the past two weeks, his largest single holding gold has taken a
tumble and might have much further to fall . No investor should be judged by a
single nine-month period, and perhaps Paulson will ultimately prove to be
"right" about financials. Many banks appear cheap on paper, and sentiment is
almost universally bearish towards them. It's entirely possible that he will
eventually recoup the losses he took this year. Still, Paulson's heavy losses
on his leveraged, concentrated portfolio should stand as a warning to investors.
Paulson ignored low-hanging fruit that was ripe for the picking such as
technology and pharmaceutical shares trading at multi-decade lows based on
earnings and dividends and instead swung for the fences with a massive
leveraged bet on an inflationary expansion. Paulson risked his career and the
wealth and livelihood of his clients without ever asking that all-important
question: What if I'm wrong ? There is nothing wrong with betting big on a
concentrated position. Great value investors like Warren Buffett have made
careers of doing so, and over-diversification is a recipe for mediocrity. As the
great Sir John Templeton said, "By definition, you cant outperform the market
if you buy the market." But the second half of Sir John's quote is also
quite illuminating: "And chances are if you buy what everyone is buying you
will do so only after it is already overpriced." If you're going to take a
large, concentrated position, two conditions should be met: You stand to make a
bundle if you're right. You won't lose your shirt if you're wrong.