responding to a question

A short while ago I wrote about how professional equity portfolio managers, who are evaluated (and paid) based on their performance vs. a benchmark index approach the task of constructing their holdings. …or at least how most managers, me included, do so. I found during my career that about half my outperformance came from the sectoral layout of my portfolio–which sectors (and in many of my portfolios, countries) I had a larger weighting than the index and which I had smaller. The other half came from individual stock selection.

One point I was trying to make–and didn’t do a very good job of it–was that sometimes my strongest convictions were about what I didn’t like. I’ve never been a big fan of Financials, mostly because I find their accounting practices too opaque. I don’t like Utilities much, either. Energy is also a sometime thing for me. If these negative ideas are my strongest convictions and I want to remain fully invested (which I do), then I’m automatically going to be overweight the rest. In a sense, my portfolio is constructed backwards.

A long time reader asked how an individual investor should structure equity holdings. This is my answer.

–investing is a craft skill, like being a housebuilder or a shoemaker. You create a blueprint through sector structure, and then you also have to figure out where the studs and nails go. The latter (theme or stock selection) is a function of time and experience. Paper portfolios only go so far, in my view. I’d create one and look it every day. But I’d also start getting experience with small amounts of money in one or two stocks or funds/etfs.

You should also examine your performance periodically. Two reasons: to catch mistakes quickly (everyone makes lots of them but good managers don’t let them fester) and to figure out the kinds of things you’re good at and what you’re not.

–risk preferences are more important than you might think. You don’t want to create a situation where you can’t get to sleep at night, if the market turns down–which it does periodically. It’s important, as well, that your equity holdings be set in the context of your overall financial situation, so you don’t encounter financial problems during a bear market.

I had a brilliant but eccentric uncle, for example, who walked away from his job at a brokerage house one day (the family legend is that he was fed up paying taxes, but I think the fact his ethnicity prevented him for being considered for a job as a securities analyst was the key) and supported himself by stock trading until he died thirty+ years later. He started with $400 and ended up with $1 million+ (which was a lot back then). But he continued to live in the ghetto neighborhood he grew up in and he only bought utility stocks. He was comfortable with utilities, he needed the income they generated and their bond-like character made them relatively safe. So he balanced the enormous career risk he took by quitting with an extremely conservative portfolio.

–I have a bunch of old posts on how to get started. I’ll post links to them next week. For most people, having 90% or more of their equity money in index funds and actively managing the rest is probably a good way to start. (To be clear, however, I don’t know any reader’s individual circumstances well enough to be able to say what is right for you.) I wouldn’t hold to the professional formula for portfolio construction I wrote about above. I’d experiment with individual stocks and sector funds/etfs. The former are more work, since you’ll be reading the financial reports about your company on the SEC Edgar site. You can also look at reasonable, though abbreviated, reports from Merrill’s professional securities analysts if you open a Merrill Edge account. Morningstar is also a good source of factual information about companies and industries. You may be able to get these for free from your public library. On the other hand, if you choose a sector index fund/etf, you’re betting solely on your macro view. If you choose an actively-managed fund/etf, you’re farming out the stock selection to that portfolio manager. It’s certainly worth a look beforehand to see the manager’s track record.

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