The next thing to think out is what you hope to achieve by changing the composition of your equity holdings from the index.  This should include what you stand to gain if you’re right, what you stand to lose if you’re wrong and any indicators you are going to watch to monitor which way things are going.

Let’s lay out some parameters.  To make the math easy, assume you have $1,000,000 in stocks.  If you’re going to have 85% in the index and actively manage the rest, then you’re working with $150,000.  Of that, let’s say $100,000 will go into mutual funds and $50,000 into individual stocks.

I think a reasonable assumption for a typical twelve-month period would be that the index will gain 8%.  The leading sectors in the market may be up 15% and a good individual stock could be up 20%.  Relative to the index, then, if everything goes right for you, you might expect to gain 7%, or $7,000,  from your active mutual funds and 12%, or $6,000 from your individual stocks.  Your total would be $13,000.

It’s also  reasonable to assume rough symmetry in the markets, so that you have the potential to underperform to the same extent that you might outperform.

This brings us to the first checkpoint:  is it reasonable for you to hold anything other than index funds?  If you can’t afford to lose $13,000 vs. the index return, then you should stick with the index.  If $13,000 isn’t enough for you to bother with–the other limiting case–then again active management is not for you.

The returns you experience can also fall outside the bounds I’ve just set out.  Were they to, the main reason would most likely be the individual stocks you selected.  If this were the beginning of 2005, for example, and you bought $25,000 worth of AAPL and held it for a year, you would have more than doubled your money.  If it were the start of 2008, however, and you bought $25,000 worth of LVS and held it throughout the year, you would have lost 90% of your money.

Let’s look at mutual funds first.  If you turn back to Shaping a Portfolio IIIa, you’ll find a listing of the sectors in the S&P 500, with their approximate weights in that index.  You can alter the sector composition (and thus the risk profile) of what you hold by adding mutual funds or ETFs, in either of two ways:

you can buy sector funds that replicate the index, or

you can select an actively managed fund.

In the first case, you are exposed to the possibility that the sector you pick will perform differently (over or under) from the overall index.  In the second, you have the extra risk that the manager you pick will deliver returns that are different from the sector’s.

For now (and maybe for ever), let’s stick with sector index funds.  How do we go about selecting sectors to invest in? The answer is that we develop a strategy.  We find reasons why a given sector could perform well or badly.  We decide how much conviction we have in those reasons, so that we have a blueprint for what the portfolio should look like.  And we record what we’ve decided so that we can assess how our strategy is working when we do periodic measurements of our performance.

A strategy doesn’t have to be very detailed.  It can be something as simple as, “I think the US stock market is somewhere around the lowest level it will get in this business cycle and the next big move is up.  Therefore, I will overweight ecnomically sensitive sectors (the top of the list in Shaping IIIa) and underweight the defensives (bottom of the list).”  The important thing is to have reasons why you’re likely to be correct and to have something to check those reasons against.

Two minor tricks of the trade:

1.  Your main conviction doesn’t have to be a positive one.  In today’s world one’s strongest belief might well be that US banks are going to have a very tough time over the next few years, so the best thing to do would be to avoid them.  If that’s your only real conviction, then buy everything else in the index except the financials.

2.  You don’t have to have an opinion about everything.  In fact, you’re probably better off having one or two few well thought out ideas, where there’s a reasonable chance you know things other people don’t,  than a bunch of half-baked thoughts that are most likely to be wrong.