When big can be beautiful

History, so we are told, is a great teacher, but a poor master. For anyone who is contemplating a last-minute ISA investment for the current year, as many people seem to be doing yet again, there are some interesting historical\messages to ponder in the latest issue of CFSB's annual Gilt-Equity Study(formerly published by BZW). They are more directly relevant than you might imagine.

History, so we are told, is a great teacher, but a poor master. For anyone who is contemplating a last-minute ISA investment for the current year, as many people seem to be doing yet again, there are some interesting historical\messages to ponder in the latest issue of CFSB's annual Gilt-Equity Study(formerly published by BZW). They are more directly relevant than you might imagine.

The first thing investors need to do when considering their choice of ISA is to anchor their choice in some kind of reasonable time frame consistent with their overall investment strategy. I don't have the exact figures to hand, but experience suggests that in practice most people who take out PEPs and ISAs hold them for a reasonable length of time. I would be surprised if the average holding period for the majority of holders proves to be much less than 10 years; and while it is possible to switch from one fund to another, in practice, most investors don't take advantage of that option.

Apart from anything else, they are simply too busy to have time for the necessary homework. If that description sounds reasonably like you, then it follows you should be selecting your ISA on the basis of its expected return over a 10-year time frame, rather than trying to pick the fund which will do best over the next 12 months. At the same time, if your objective is medium-term, and you are a regular investor through this route, you clearly need to keep an eye on the impact that whichever fund you choose this year will have on the overall balance and risk profile of your total holdings of ISAs and PEPs. And bear in mind that your financial circumstances and appetite for risk will inevitably vary over a lifetime.

The kind of questions you need to ask are: how much of my portfolio is in the UK and how much overseas? Are all my investments concentrated in the FTSE 100 index, or are they spread throughout the market universe, to include smaller company shares as well? What is the balance between passive (tracker) funds and actively managed ones? Do I have too much invested with just one fund management group? What is the cost burden that my funds are carrying?

The point of course is that if you just blindly buy the fund or funds that are top of the current performance tables, it may or may not turn out to be a successful choice, measured in relative or absolute returns. The evidence is that following that path will not produce exceptional returns over your 10-year horizon, and may in fact do less well than average. It is not easy to predict what markets will do. What you can be fairly certain of in advance is what impact the kind of fund you choose will have on the overall risk-reward balance of your portfolio.

This is where the historical perspective comes in. It only seems logical that if you are looking at a 10-year time horizon, what should be of most interest to you is how different investment strategies have fared through history on that kind of perspective. The CFSB study can help here. It reaffirms the now well-known fact that there has never been a 10-year period in the past 100 years when equities in aggregate have failed to produce a positive total return, although the dispersion of 10-year returns is obviously wide.

Even at today's inflated levels, there is still a strong case for building your portfolio around the stock market, though you should note that the case is much less robust than it appears once you take taxes and the actual costs of owning shares (say 2 to 3 per cent a year) into account. Unless you believe strongly that the low-inflation environment is at risk from rising oil prices (a current worry in the markets) or a Wall Street crash (the perennial bugaboo), then it remains the case that equities in some form are the best core to any medium to long term portfolio. If your assets are already largely or totally concentrated in shares, it is only common sense to reduce your exposure a little when prices are historically very high (as they are now) and add to them when shares are historically very cheap (which is not where they are today). This is a form of diversification against valuation risk, the oddity being that most people are tempted to do the exact reverse, preferring to buy when things are expensive and sell when they are cheap - a policy that makes sense only if your time frame is actually very short.

The real choices for those who, having done this test, still want to add to their equity exposure are: which countries and markets? Large or small cap bias? Which type of fund? And which management group? The very last question you should ask on a ten year view is: which funds had the best track record over the past three years? The reason is that, quite apart from telling you nothing about their likely future performance, it tells you nothing about the most important considerations, which are your own objectives and the current balance of your portfolio.

On risk grounds, the safest place to hunt is still among large well-capitalised companies, provided you can get enough diversification. The CSFB study shows if you had bought the 100 largest companies by market value in 1965 and held them for 30 years (or until they disappeared through takeover etc), you would have beaten the total stock market by an average of 7 per cent compound, a more than useful edge. Interestingly, two thirds of the 100 biggest companies in 1965 subsequently underperformed the overall market.

But this was more than offset by the fact that those which did beat the market did so by a sufficiently large margin to compensate for the failure of the majority. Big is beautiful only if you pick the right stocks. As the table shows, many companies have short life cycles and are simply outpaced by competition. The moral is that unless you can really pick the companies that are going to endure, you may well be better of sticking to a well-diversified portfolio, essentially the argument for index funds. An alternative strategy that has produced good results is to buy the 10 largest companies by market value at the start of each year. That, too, has outperformed the market as a whole. Even here, the minority of exceptional performers make up for the underperformance of the majority. The danger with pursuing a large cap only strategy this year is that the market has never been so concentrated in its upper reaches.

As the graph shows, the 10 largest quoted companies account for more than 40 per cent of the entire capitalisation of the UK equity market. This is well above the long-run average, and the highest the proportion has been in living memory.

What is more, the UK market is now heavily concentrated by sectors, with five sectors accounting for 70 per cent of the Footsie index's total value. So the risks in buying big are greater than they have been historically.

Next week, I shall discuss in more detail some practical ways in which investors might wish to direct their ISA money against this kind of market background.