What We Have Learned So Far: A Brief Recap
In the financial article Smart Investors Know the Sectors, we touched upon Portfolio Management and the benefits of holding two types of portfolios: a Core Portfolio and an Explore Portfolio. A Core Portfolio is for investments, and an Explore Portfolio is for Trading.
Before we take a deep dive into the fundamentals of how to build a Core Portfolio, let’s pause, step back for just a moment, and remind ourselves about the rationale and the differences between the Core and Explore Portfolios.
If you recall, the Core Portfolio of holdings will become our primary growth engine and our source of security as we pass through the stages of life.
It should consist of strong, legacy type companies like a farm, that we would not want to sell, because we know that over time they will continue to operate with efficiency, and we can pass them down to our heirs as part of our legacy.
The Core Portfolio serves as the “nucleus” of our holdings, whereas the Explore Portfolio contains growth opportunities, much riskier in nature, but which have the potential to dramatically increase our returns:
The challenge in managing any portfolio is making the right decisions at the right time to maximize returns with the least amount of risk.
Because the Core Portfolio and the Explore Portfolio have different risk and return profiles, and because the Core Portfolio will serve as our nucleus, it is prudent to focus on the Core first. A discussion on how to develop an Explore Portfolio will be covered in another article.
The time is right to take a deeper dive into the investment strategies on how to build the Core Portfolio:
The Essential Ingredients of a Core Portfolio
The Core Portfolio consists of holdings, or shares of ownership, from strong companies in various asset classes, sectors, and industries.
These shares of ownership are traded in stock exchanges, and the stock markets are the places where investors and traders come to exchange shares of ownership in the various companies.
The shares of ownership which are traded publicly include companies which meet the criteria for registration as an approved security for legitimate investment by the public.
Some of these criteria include the legal structure of the company, the forms of accounting systems and associated governance, the size of the revenues, the accountability of the officers, and the assurance that the company actually produces goods and/or services. Stock issuance is heavily regulated to ensure that these criteria are met prior to public offerings.
Please remember that the S&P 500 is a stock market index that consists of the 500 largest US companies in ten key sectors. It is considered to be one of the best representations of the entire US stock market and therefore, of the entire US economy.
The pie chart below represents the percentage of each sector in the S&P 500 Index. Ultimately we will want our Core Portfolio of holdings to resemble the percentages in the S&P 500 allocation, or something similar.
But, with so many companies to choose from in each sector, new investors are often overwhelmed with where to begin.
Swamiji simplifies this by breaking our decisions down into two key components. First, we need to decide how we want to manage our assets. Second, we decide how to select good core assets and maintain profitability through a few dynamic portfolio strategies.
Let’s focus on the first decision — how to manage our assets.
Key Decision #1: How to Manage Our Portfolio
There are three basic approaches we can take to manage our portfolio: Manage by Ourselves, Have Professional Management, or a Combination of the two.
There are Brokerage accounts that are operated exclusively by the investor, accounts that a Broker operates on behalf of the investor, and accounts that are operated by a Broker with the advice and consent of the investor.
Self Manage is the first approach, and it can be done by:
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- Purchasing shares in a mutual fund or in a family of funds.Mutual funds are a collection of securities, managed by professional money managers, and are funded from a pool of money collected from many investors.Mutual Funds provide small investors access to a professionally managed diversified portfolio of assets, which would be quite difficult to replicate with a small amount of capital.
- Investing in Exchange Traded Funds, called ETFs.ETFs are groups of stocks bundled together according to every kind of criteria which you can imagine: according to exchange, according to sectors, according to industries, countries, groups of companies, momentum stocks, volatility stocks, indexed, and actively managed.An ETF trades like a stock on the stock exchange, and it allows a small investor to diversify, while providing the transaction flexibility of a regular stock.
- Picking your own mixture of stocks in individual companies from the various sectors of the world economy.
Professional Management Through a Brokerage Account is the second option.
There are many kinds of Brokerage Accounts, through which you can manage the various functions of investing. A “Full Brokerage Account” offers many kinds of financial products, recommended by your Broker, selling investment opportunities under various broad categories:
- Indexed Funds – a fund which maintains defined percentages of sectors and industries.
- Managed Funds – a committee of investment analysts pick individual stocks from specific industries and companies, and dynamically manage the assets according to market opportunities.
- Individual Stocks – equities in specific companies recommended by your Broker according to your investment objectives.
Combination of Self Manage and Professional Management is the third option.
So when we want to design our Core Portfolio of holdings, that will become our primary growth engine and our source of security as we pass through the stages of life, there are many options from which to select.
Sometimes we will want professional management, sometimes we will want to do it ourselves. In most cases from time to time, we will have a mix.
But, no matter how much we are personally involved in managing our assets or not, the responsibility still remains with us!
They are our assets, it is our future, and there is no substitute for an educated, aware, responsible investor.
Pay attention! Cautious investors are wise investors!
At any time in investing, greed can take over. Actually fear and greed are the two most prolific motivators in this kind of business.
In the article Smart Investors Know the Sectors, we discussed investor psychology in terms of the emotions that we can feel during the economic cycle. But, in addition to this, please be aware of those you hire to manage your assets.
There will always be a “Bernie Madoff” type character, who can try to make off with your assets. Ultimately, YOU are the party responsible for your assets. Please pay attention!
The people who work for you will be only as diligent as you are. Please be diligent!
Your knowledge is your power. Approach all of your managers as educators! Ask them to teach you. They must, or risk losing your account.
Each of them will be happy to share his or her understanding. If they are not, they do not understand, and you should not be partnering with them. If they do understand, then be proactive and learn from them.
Key Decision #2: Asset Selection and Portfolio Management
Regardless of whether you are going to self manage your assets or hire a professional money manager, you will need to understand the basics of Portfolio Management.
Here are three simple steps to get you started and help you prosper:
Core Portfolio Step #1: Choose Strong Companies
As mentioned earlier, new investors are often perplexed with which companies to select as part of their Core Portfolio.
Our Swamiji has clarified this for us. He says, “Before you get exotic, and try to invest in the latest startup, which you heard is making a killing on Wall Street, start by being boring: invest in the companies whose stuff you use every day. It’s that simple!”
These “every day” types of stocks are not going to wow you, excite you, romance you, or even make you a killing in the market. But, most likely these types of companies will produce consistent, reliable returns and over time, the value of these companies will increase with the growth of the population and the economy.
Our Core Portfolio of holdings should be a collection of companies diversified across sectors and industries. They should be companies that you have heard of, businesses whose products or services you use, and things that you know about.
For example, you all have a shelter called home, food and household products, a telephone, probably a computer and a car. You all use energy, watch TV or some form of media, go to a doctor, buy insurance, or have a bank account. What products and brands do you use?
Start with what you know. We know that we use these things today, and most probably we will continue using these things in the future. Think of the companies that you use to supply the goods and services you require, remembering to diversify. You will want a bank stock, an automobile manufacturer, an oil company, a health care stock, a utility company, a consumer products company, and a telephone company.
What an excellent place to start! If you need these kinds of goods and services, probably almost everyone else does too!
As you become more comfortable in investing, you may choose to do more research and apply a little more rigor in the selection process. One proven methodology is to evaluate a company’s “brand equity.”
Brand Equity is the value of a brand from a consumer’s perspective. The value of a brand can be understood by assessing brand awareness (how well-known is the brand), the perceived quality (how well does the brand fulfill consumer’s expectations), and brand loyalty (how much do consumers demand that particular brand versus competing brands).
Those companies that rate favorably on these three attributes will be great parts of the Core, providing reasonable, stable, returns through time. There are several examples of companies that have great brand equity – Coca-Cola, Apple, Google, Samsung, Amazon, Nike, and Toyota are just a few.
In addition to brand equity, there are numerous other factors to consider when trying to evaluate the value of being an owner of a share of stock, such as: economic market fundamentals, company specific financial fundamentals, technicals (statistical prediction of future using historical data), the future of the industry, guidance for the company, actual performance, and stakeholder perception.
Core Portfolio Step #2: Assess External Conditions
As we define and construct our Core Portfolio, let’s make certain assumptions about our world by asking questions such as these:
- Is the world’s population growing? Will there be more people in the world in the future?
- Are there more young people in any certain countries more than old?
- Is the standard of living improving for people in certain countries?
- Is the cost of living increasing?
If we believe that any of these propositions are true, then we must believe in a continual increase in economic activity. This is typically indicative of a “bull” market in which share prices are rising and buying is encouraged.
This is an environment where there is an increase in population and an expansion of the number of young, energetic, new families, who will require more food, shelter, communications, more goods and services. This creates a strong economic foundation for growth in the markets.
The most useful indicator of economic growth is the measurement of the output of goods and services in any area, called Gross Domestic Product or GDP.
When the GDP in any area increases, it is because there have been increases in the productive output of the companies of that area. That is, as demand grows, supply grows accordingly to fulfill the requirements.
As production grows, companies become more profitable, and the profitability of a company is measured by what investors will pay for a share of ownership in that company.
Indeed, the line chart shows that the S&P 500 is highly correlated with GDP.
Core Portfolio Step #3: Continuously Adjust and Re-adjust
Though our general investment strategy for the Core Portfolio is to buy and hold, even amongst our Core holdings we will find that investing is a dynamic process requiring constant readjustment.
Readjustments could include such things as taking profits, liquidating losers, balancing sectors, balancing industries within those sectors, analyzing new opportunities, and minimizing tax consequences.
We will often rotate and rebalance our holdings to achieve consistent growth in our portfolio of assets. The terms “rotate” and “rebalance” are fundamental strategies in portfolio management with which you will want to understand and implement.
Rotation Portfolio Strategy simply means selling stocks in a popular sector of the economy and buying undervalued, less popular stocks in another sector.
It is also called “Sector Rotation” and “Stock Rotation.”
We will want to rotate (add or decrease holdings in any one sector) as opportunities present themselves. Sometimes, various sectors will grow at different rates, at different times in the economic cycle, and according to geopolitical influences as well.
For example, a Rotation Strategy is sometimes used to diversify holdings over a period of time, as not all sectors of the economy perform well at the same time.
It can also be used to profit through timing a particular economic cycle, such as exiting a sector should it begin to struggle, while entering another sector as it begins to rise.
Rebalancing Portfolio Strategy is the process of realigning the weightings of our portfolio of assets. It involves periodically buying or selling assets in our portfolio to maintain our original desired level of asset allocation.
From time to time, we will also see that some sectors have grown disproportionate to other sectors, and we will want to rebalance our allocations among the sectors.
At other times we will believe that some sectors may outperform the rest of the market, so we will want to increase our allocations and purposely be overweight in those areas.
A simple example of rebalancing is, let’s say your original target asset allocation was 80% stocks and 20% bonds. If your stocks performed well compared to your bonds over the course of time, your stock weighting would have increased — let’s say it grows to 90% of your holdings. You are now out of balance with your original objective of 80% — 20%. You may then decide to sell some of your stocks and buy bonds to get back to your original target allocation. This is known as a Rebalancing Strategy.
While there will be numerous reasons to readjust our holdings, a few others are listed below:
- Take advantage of a tightening of the supply and demand in the energy markets, which will cause commodity prices to increase resulting in an increase in the value of energy stocks.
- Jump into the Technology Sector should there be a general excitement causing IT stocks to rise.
- Reduce holdings in the Consumer Discretionary Sector should unemployment trends increase or an apparent recession be looming.
It is clear that we should continuously monitor and measure our performance, and rotate and rebalance appropriately.
As we gain experience in managing our portfolio, we will learn about more about the markets, the sectors, the industries, and the companies. We will ultimately be able to better intuit the right moves at the right time.
What To Do in an Economic Downturn
We have learned the key fundamentals of how to build a Core Portfolio as well as steps to manage it on a continuous basis to generate consistent, reliable returns.
But, what do we do in a market downturn?
For example, in the first three months of 2014, there was an extremely heavy snow-fall all across the United States. People didn’t feel they should go shopping because of the weather. Who wants to go shopping for a new car in the midst of a snow-storm?
So, of course, when sales slowed, demand for products slowed. When demand lessened, production slowed. When plants cut back their production, then restaurants, entertainment, discretionary services, all were impacted. When earnings decreased, the value of company stock decreased accordingly. It completely rippled through the entire economy.
But do you want to sell the family farm because this one crop went bad?
That is the judgment call that each one of us must make with each announcement from the companies we follow, and according to the other financial needs of our personal situations.
That is what it means to be an investor in a Core Portfolio.
Om Namah Shivaya!
