Shaping a Portfolio for 2010 (IIIa)–First Steps

General Principles

I’m supposing you’ve done enough financial planning to figure out how much of your assets should be in stocks.  It’s the stock portion that I’m writing about here.

A neutral position is holding an index fund.  The most common index to use as a performance standard for US investors is the S&P 500.  Holding the neutral position will get you whatever the return on the index is, less fees charged by the fund manager.  As a general rule in selecting an index funds, the more assets the better, because that usually means lower fees.  Typically Vanguard funds charge less than others.

I’ve always thought of investment risk as being deviation from the neutral position. You don’t change from the index position just for the fun of it.  You take out things you expect to have an inferior return and put in things you expect will have superior performance.  This is harder than it sounds.  The industry cliche is that a professional investor who is right in these choices 55% of the time is a hero, and one who’s right 45% of the time is unemployed.

The simplest ways to diverge from the index are to buy an ETF, buy shares in an actively managed mutual fund (where the manager assembles a collection, usually of 50-100 stocks that he thinks will do better than the index) or to buy shares of individual stocks.  You can also use options, futures or other derivative instruments, or sell stocks short, but these are highly specialized things that I think most investors should avoid.

Academic research over long periods shows that the typical active manager in the US market doesn’t do better than the index, even before the fees he charges, and almost no one beats the market after fees.  (I think the record is somewhat better for US-trained managers investing in foreign markets.)  Academic research also can’t find a performance difference between mutual funds that levy sales charges (called load funds, usually sold by traditional brokers) and those that don’t (called no load and sold by discount brokers), other than that the sales charges reduce the net returns to the shareholder.

Conceptually, you can change the structure of your holdings vs. the index in a number of ways.  You can:

change the sector weightings, but keep the sector’s

stocks in the same ratio as the index;

change the relative size of the stock positions, but hold

the sector weightings constant;

substitute stocks not in the index for those in the index.

An individual investor can do the first by buying a sector fund, active or passive (index).  You can do the second by buying an individual stock that’s contained in the index.  Strictly speaking, you can’t do the third without shorting an index stock, but you can come very close just by buying a stock that’s not in the index.

How This Works

Let’s assume you’ve decided to keep 85% of your equity exposure in an index fund, another 10% in two sector funds, and the final 5% in two or three individual stocks.

The S&P 500 industry structure is roughly as follows:

Technology                                            18%

Industrials                                              10%

Consumer Discretionary                          9%

Materials                                                 3%

Energy                                                   13%

Financials                                               11%

Healthcare                                             15%

Consumer Staples                                 13%

Utilities                                                   4%

Telecom                                                  4%

The more economically sensitive industries are at the top of the list, those with cash flow that remains relatively steady no matter what the general economy is doing are near the bottom.  If you were simply to want to try to benefit from changes in the business cycle and you thought the economy was about to turn up, you would be deemphasizing the industries at the bottom of the list and building up your exposure to the ones at the top.  This is exactly what the market appears to me to be doing at present.

There are other things to consider, as well.  I’ll be writing about them in my nexts posts.