February 16, 2010

Building Portfolios on the Road to Independence. Part III: The Role and Use of Equities

The topic this week is how I use stocks in building client portfolios. First let me say that I do not consider myself a stock picker. I learned years ago that trying to forecast the price of an individual issue in the near term is very difficult, if not impossible.

Around 1997, while working for the "Bull," one of their stock analysts predicted that Compaq would rise to $47 per share from its current level of $37. Not only didn't it rise, but it proceeded to fall to $27 and then fell into more trouble (as I recall). Similar stories are innumerable. There are a multitude of potential problems in selecting individual stocks, not the least of which is to understand how investors, as a group, will feel about a company's prospects. You must predict whether they will be buyers, sellers, or neither.

Because human behavior is such a key factor, but is so unpredictable, I prefer to delegate this task to managers of mutual funds and ETFs. I should mention, in case it wasn't obvious, that I will use the term "stock" in a categorical sense and not as a reference to individual issues.

During the bull market of the 1990s, an aggressive portfolio might have contained 80% or more in stocks. Even a balanced portfolio was 40% to 60% stocks. Since returns cannot be controlled, but risk can (at least to some extent), here's how I allocate my portfolios (stocks/bonds/cash/alternatives):

o Conservative (16/68/3/13)

o Moderate (35/43/3/19);\

o Aggressive (50/24/2/24)

At first glance it may appear that the aggressive portfolio is not very aggressive since it has only 50% in stocks. Here's my rationale behind these allocations.

Premise: Whenever adding a holding to an existing portfolio, the new addition must have a positive effect on the portfolio. I define "positive effect" as either reducing risk or increasing the return potential. Moreover, stocks will dominate the movement of the portfolio unless its allocation falls below a certain percentage, such as 17% (+/-). Since stock fluctuations are so important to the risk or volatility of the portfolio, I assign a substantial allocation to alternative investments.

Ideally, alternatives will help calm the portfolio and reduce its overall risk. Therefore, as the percentage of stocks increases, the percentage of alternatives should also increase to reduce the portfolio's risk.

I prefer Value over Growth and overweight Large-Cap over Mid- and Small-Cap. I also allocate a larger percentage to domestic over foreign. I might get a little tactical with the mix of domestic and foreign depending on the strength or weakness of the dollar.

Obviously, there is so much more to discuss, but I'll have to leave it there for now. Next week, I'll discuss alternative investments.

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