Shaping a Portfolio for 2010 (IIIc.)–Risk Control

To recap from earlier posts:  we’re assuming that you have 85% of your stock exposure in an S&P 500 index fund.  Of the remaining 15%, you intend to put 10% into sector mutual funds (again, index funds, unless you have strong reasons to do otherwise and a commitment to monitor your progress).  The rest goes into individual stocks.

It’s very important to figure out how adding either mutual funds or individual stocks changes the risk composition of your portfolio vs. the S&P.   You want to do this so that you understand the amount of risk that you’re taking on.  But you also want to avoid two kinds of bad outcomes in your equity structure.  You don’t want to end up with what looks like a portfolio but ends up being a gigantic bet on a single idea, as would be the case if you had a bunch of holdings but they were MSFT, CSCO, INTC, a software fund, an internet fund and an IT hardware fund.  On the other hand, you don’t want to end up with bets that cancel one another out.  For example, I once took over a portfolio from a(n unsuccessful) manager who had loaded up on oil and gas stocks, on the idea that energy prices would rise, but also held large amounts of petrochemical stocks, which would only do well if energy prices fell.  So the 20%+ of his portfolio that these two positions represented was just a waste of time.

Mutual funds:  There may be industry groups, like biotech or internet or telecom, that you have very strong conviction in.  If so, you would buy funds in these areas, adding to your health care, technology or telecom weightings.  Let’s assume instead, though, that your strongest conviction is that, as far as the stock market goes, we are past the worst and the next major move is up.  So you want to use your mutual fund 10% to create a general overweight in the (four) most economically sensitive sectors.

From an earlier post, you can see that these sectors are:  technology (18% of the index), industrial (10%), consumer discretionary (9% ) and materials (3%).  Probably the easiest way to deal with materials is through a natural resources fund, which will also have energy (13%) in it.

You may want to keep track of what you’re doing on an Excel spreadsheet.    You will probably go through a number of iterations of the process, both for mutual funds and again after adding individual stocks, until you’re satisfied with the ultimate risk profile you’ve established.  Also, you want a record of your thought process so you can analyze and critique it as results come in.

List the sectors and their weightings on the spreadsheet and reduce all the entries to 85% of the original number.  That’s your index position.  Add 2.5% to  each of the four sectors mentioned above, which will make your weightings add up to 95%, and recalculate the new weightings as percentages.  You should see that you’ve added about 1.5 percentage points to your consumer discretionary weighting, 1.4 to industrials, .8 to natural resources and .6 to technology.

Then consider individual stocks.  Here, the most important consideration is that you understand the company and have reasons to think it will do well, especially with US stocks.  (The US is a stock picker’s market.  It’s nice to have a favorable industry tailwind, but it’s not as crucial as it is elsewhere stock markets. ) As far as your portfolio goes, your individual stock choices may tend either to increase the sector bets you are making through mutual  funds or to reduce or negate them, depending on what industries the stocks fall into.

Assume the stocks you decide to buy are AAPL and TGT (these are high-quality companies but I don’t own either), and you’re going to have 2.5% of your portfolio in each. Add 2.5% to the IT percentage in the 95% column and another 2.5% to consumer discretionary.  This will give you 100%.  Subtract these weightings from the index values to see what your over- and underweights are.

You should have overweights of about 2.3 percentage points for the IT sector, 1.0 for industrials and 3.7 for consumer discretionary.  Natural resources (materials + energy) should be about neutral and the other sectors underweight.

Adding up your overweights gives you 7, which is the same as the underweights.  You can gain outperformance if the overweights work out or if the underweights work out, or both.  If we say an outperforming sector will do 7% better than the index and an underperforming sector will do 7% worse, then you stand to make .49% of your portfolio in performance from each side (7% of the portfolio deviating from the index times 7% in extra return =.49% of the portfolio in performance).  So, in a market that’s not particularly volatile, you can gain (or potentially lose) about 1% of the value of our portfolio from your sector setup.

You have additional stock-specific risk in the equity holdings.  I’ll talk about that in a later post.

You may be tempted to dial the risk level up from what I’ve described.  Until you get more experience and feel more comfortable with this approach, I wouldn’t do so.  It’s relatively easy, psychologically, to dial up the risk level (but not too much) once you’ve been successful.  But it’s very hard to do the reverse.

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