My Personal Finance Journey

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Reengineering My Portfolio Management, Part V: Portfolio Construction

Contributed by mm | February 20, 2007 1:04 PM PST

So, how should I build my portfolio using tools like mutual funds, ETFs, stocks, bonds and money market accounts to achieve the asset allocation plan I desire?

Many financial columnists advocate, for good reasons, that once the asset allocation of a portfolio is determined, one can simply purchase passively managed index funds for each asset class. The reasoning? Majority of actively managed funds fail to beat the index (read: market) after fees, so one will save time AND achieve market performance by simply picking the lowest-cost index fund.

I have to admit there is some wisdom in this line of thinking. For most individual investors who have no time nor interest in learning how the market works, it will be a challenge to differentiate between the thousands of funds in the market, and to appreciate those that are consistently beating the index. Therefore, a plain-vanilla solution of index investing is a great solution.

However, the truth is in every asset class, a number of funds are consistently delivering market-beating returns. These popular shops include Oakmark, Dodge & Cox, Longleaf, Legg Mason and Third Avenue in equity and PIMCO and alike in fixed income. (One may argue that the sheer number of equity funds in the market ensures that there will always be a few funds will have the lucky streak to beat the market over a decade. However, the fact that among the market-beating pros there is a concentration of fund managers with similar value investing mindset seems to support that some schools of thought can consistently deliver the alpha.)

Therefore, instead of holding index funds for market average return, I plan to own a number of actively managed funds -- I do believe I will be rewarded with a few extra percentage points of "alpha." (For our 401(k) accounts, I have to settle to the short list of investable funds.)

In addition, I intend to (continue to) hold some individual U.S. stock positions -- most of them will be large-cap companies. First, I have a vested interest in learning stock market and different lines of business. I also have professional knowledge in understanding corporate finance, and my (post-retirement) life will be boring without looking at the numbers once in a while). Second, investing in individual stocks allows me to better track to my absolute return goal of 10% -- by setting an expected return and allowing enough safety margin, one can largely calculate the rate of return should the price of a stock returns to its intrinsic value.

For the record, I have good success so far in my stock picking: my stock portfolio beat the market in 5 out of the last 6 years, and achieved an annualized rate of return of 17% since April 2000, when the market peaked. Many painful lessons after, I am also conducting more due diligence and consciously moving away from exotic small-cap picks -- all these should improve my batting average moving forward. In addition, I am growingly more patient -- I've held the 12 outstanding individual stock positions I had as of January end for an average of 1.5 years.

To summarize, here is a list of allowable investment vehicles in my portfolio, by asset class:

Domestic Equity (Target Asset Allocation = 45%):
30% in Large-Cap/Mid-Cap Stock Picks
15% in Mutual Funds that Specialize in Mid-Cap, Small-Cap and All-Caps

Foreign Equity (Target Asset Allocation = 35%):
Mutual Funds
ETFs (When Quality Mutual Funds Cannot Be Found for Particular International Stock Segment)

Cash & Fixed Income (Target Asset Allocation = 15%):
Money Market Account
Certificate of Deposit (CD)
Savings Bonds
Quality Mutual Funds and ETFs That Specialized In Fixed Income or Bank Loans
Exotic Tools like

MSFT Stock Options (Target Asset Allocation = 5%):
Vested MSFT Employee Stock Options (Of course)
Other MSFT Option Plays in Open Market (to reduce the risk of Employee Stock Options)

In the next few posts, I'll be discussing the process of choosing the individual stocks and mutual funds to build out the portfolio.

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This Post Has Received 4 Comments. Share Your Opinions Too.

Brian Commented on February 21, 2007

Great exercise, thanks for sharing. Do you view your non-tax sheltered accounts as part of your retirement portfolio (i.e. individual equities)? Also, how to decide what percentage of the entire portfolio should be in tax-sheltered vehicles? I've been very confused about these matters in managing my own finances, with conflicting views from 'professionals.'

CPA1298 Commented on February 21, 2007

You say, "...I have to admit there is some wisdom in this line of thinking..." (eg. investing in index funds). In a year when 80% of index funds beat the market, I think there is a little more than 'some' wisdom in indexing.

You continue, "...For most individual investors who have no time nor interest in learning how the market works...a plain-vanilla solution of index investing is a great solution." Maybe these investors could also be the ones who have taken the time to learn that the markets work very efficiently, and that it is virtually impossible for anyone to consistently beat them?

It is interesting to me that Warren Buffet earned nearly all of his "alpha" on about 6 stock picks (Coke, Geico, etc). It is scary that without a handful of selections his performance would be only average. I have the feeling that over time, "alpha" is attributable to luck, not cunning wisdom.

JoeKer Commented on February 21, 2007

CPA1298, I suspect there is a lot of truth to what you are saying - that getting consistent alpha is more luck than systematic smartness. However I do think that some folks can be smarter than the market even over the long term, at least selectively. Not everyone is capable of this and even the best will fail very often but I do think I have seen enough experiences of people who have made the right call. My comments apply to not just stock picking but risks people take in general.

Buffet probably saw some long-term trend that the market had not factored or considered too risky and it paid-off (more than 6 stocks I think, right on metals and silver, too early on the dollar, energy - TBD). One might call this gut-feel or luck or whatever but many entrepreneurs will tell you that this was the factor that worked for them. I have a couple of personal examples where this has worked. I started buying Brazilian and Indian ADRs back in 2000. I just felt that these economies would pick up despite the fact that the market considered them very risky assets and based on an efficient market theory had priced them accordingly. I have done very well on those stock picks. Was it luck or gut-feel? I admit, most of what has unfolded are not what I thought would happen ? Indian software explosion although I did factor that and also Brazilian economy turnaround. Who knows if one chalks this down to luck or smarts but it has worked. I have other examples. One does need to have the appetite for the risk.

On MM?s investment strategy - I do think that this is possible ONLY with individual stocks and perhaps with pvt equity funds and hedge funds. In general it will always be a situation where the few winners you pick beat out the losers and the law of large numbers starts working very quickly. I do agree with CPA1298 that it is very difficult for a fund (which has more than 20-30 stocks) to do this and an investor is much better off with a low cost index fund.

Buy antivirus online Commented on May 10, 2007

Hello everyone, wanna be part of some kind of community, possible here? anyone here?

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