a portfolio review

I’ve been doing a general review of my portfolio over the past few days.  It might not be a bad idea for you to do something similar–assuming that like me, you haven’t done something formal recently.

why now?

The “official” reason is that we’re more than a year–and a doubling in the S&P–away from the lows of last March.  A lot has changed since then.  Also, from trying to observe my own quirks over the years, I know that when I start to become too interested in the day-to-day movements in the actively managed part of my holdings (confusing brains and a bull market, as they say) stocks are at a near-term top.  I also think there’s a reasonable argument to be made that, entering year two of the bull market, we should take a more selective approach to active management than simply noting that the elevator is going up and making sure we’re on it.

I’m not advocating a change in overall strategy.  Recovery has barely begun, so it’s much too soon to think about becoming defensive, in my view.  But the investing landscape has changed a lot in the past twelve months.  I don’t think of this so much as spring cleaning, but rather pruning back the bushes and pulling out the weeds.

I’m looking at four things:

overall asset allocation

Suppose you think you should be holding 60% stocks and 40% fixed income, including cash.  (The traditional rule is that your stock allocation should be 100 minus your age–40% for a sixty-something–with the rest in bonds/cash.  This rule was made up before many people started living into their eighties and nineties, so I think it shortchanges stocks.  But that’s an issue for another day.)

Suppose also that you were too stunned to rebalance a year ago and were holding 50%/50% at the bottom.  If the fixed income half didn’t include a large chunk of junk bonds, which really have a lot of the risk characteristics of equities and arguably shouldn’t be counted as “safe” investments, you’re probably now holding 75% stocks and 25% bonds.

As a stock guy, I hate to say it, but that’s probably too big a deviation from your target asset allocation.  Rebalancing is in order.  You can console yourself with the thought that in the coming year the difference in returns between stocks and fixed income likely won’t be anything nearly as dramatic.

position sizes

It seems to me that any deviation from index funds in the stock portion of your holdings has to be large enough to make a meaningful difference to your wealth if you are correct, but not so large that it blows a huge hole in the bottom of the boat if you’re wrong.  For me, that translates into an individual stock or specialized mutual fund/ETF holding being at least 1% of the total but no more than 5%.

An aside:  Just as a fact of arithmetic, it’s hard for  a position that starts out as 2.5% of a portfolio to become a 5% position.  To get there, the stock/fund/ETF has to achieve the return on the portfolio plus 100%.  Unless the other 95% has been an unmitigated train wreck–and with mostly passive investments it shouldn’t be–this is a real feat.

Reaching, or exceeding, your maximum position size should mean automatic pruning.  In my case, I have a couple of stocks that I added to last March-April that I feel I have to cut back.

target prices

Not every stock is an AAPL, offering the possibility of above-average growth for a far as the eye can see.  Many companies, in contrast, are relatively mature.  Their profits rise and fall with the economy, and their stocks trade in predictable patterns relative to their prospects during a business cycle.  For such stocks, investors normally set target prices, at which they intend to sell the stock, before they buy.

A given issue may trade at, say, 10x peak earnings for the cycle, and may reach that level a year before the peak earnings period.  In that case, your plan is to forecast peak cycle earnings and sell the stock when it reaches the 10x price.

For each actively-managed position you have, it’s important to have a plan.  This is a good time for seeing where cyclical stocks you own stand vs. your selling target.

clunkers and small change

Every portfolio has its dirty secrets, the stocks your eye jumps over rather than take a good look at how it has performed.

There may also be positions that you started to build but never completed for one reason or another.  These ones are too small to make a positive contribution, so the only thing they can do is make trouble–sort of like weeds.

Entering year two of an up market, every stock has had its chance to show how it can perform.  If it hasn’t done what you’ve expected, there are two questions you should ask yourself:  do I still believe in this stock? and…is there something better I can do with the money?

For small positions, an investor should make them bigger or make them go away.  You may hold onto them for some other reason–just recognize that these may be indulgences to your vanity, not investments.

There can also be small positions that started out as big positions.  Everyone has them.  The investment calculation–where do we go from here?–doesn’t really change because of the stock’s cost basis.  The only way in which the analysis differs is making sure you use the value of the tax loss in a taxable account.

Summary

Look at your actual asset allocation vs. your target.  Prune back your large positions, as needed.  Pull out the inevitable weeds.