Portfolio Construction - Outperformance

If you want to outperform the market, to build a better portfolio, then you have to be willing to do things differently than most of the herd.

First among these is committing to your positions. Today, this is called a "focused" portfolio or if a mutual fund does it, a "focused fund". Recent academic studies have shown that focused funds perform, on average, a couple of percentage points better than the typical fund. This is no surprise really, since you are willing to commit more capital to those positions holding the best promise.

While some diversification has it's place, too much will produce only market performance at best. Think of it like a game of Texas hold 'em poker: If you got dealt two aces "in the hole" to start the game, would you start off with an average-sized bet? If you did, you'd be wasting your huge advantage.

Investing is like that too: you should commit larger amounts of capital to the most promising positions, and less to the ones which are still promising, just less so.

I personally think that no one who wants outperformance should have more than 25 positions, and that the minimum amount of any position should be at least 4% of the portfolio value. Without being willing to commit at least 4% of your capital to a position, shows a lack of confidence in it, perhaps underpinned by a lack of understanding of it, its industry, etc. In that case, you shouldn't invest at all.

In some exceptional cases, you might want to commit 20% or more of your capital to an exceptionally promising situation. Superinvestor Warren Buffett has remarked that early in his career he held over 50% of his net worth in a single stock, and slept like a baby every night (presumably because he felt the stock was remarkably under-valued).

You need to ask yourself a few questions before your undertake your purchase - before deciding on the percentage of your portfolio you're going to commit to it:

1. What are the odds that something could go wrong with this stock, and
2. If something goes wrong, how much damage will it do, and
3. If things go as I foresee, how much upside does this add to my portfolio?

When you can answer these questions to your satisfaction, then you'll have an idea how much capital to commit. Never forget to build a "margin of safety" into all your estimates.

Thinking differently: the first step to outperformance.

JW

The Confused Capitalist

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Financial Leverage: $3.05 Diversification

An important safety component in any portfolio is based upon diversification. That means NOT buying companies that are all in just one sector or industry. This protects a portfolio against a dramatic cyclical decline based on one industry or sector weakening over time. Against that, hopefully other companies or sectors held within our portfolio will be experiencing an asendancy in their fortunes.

In short, diversifying sufficiently protects our portfolio, provides possible enhancement of returns, and best of all - allows us to sleep well at night.

Let's consider this portfolio. While it lacks some components of diversification (such as smaller companies, foreign companies, and emerging market companies) the large companies are well-suited to having the probability of providing a steady stream of dividend income to us - a very important consideration. So we are mainly looking to see that we haven't inadvertently selected companies in just one market sector. So let's look at them:

1. ATT - Telecom
2. Altria - Tobacco / Food
3. Bristol Meyers Squib - Pharmacueticals
4. Conagra - Foods
5. Progress Energy - Utilities
6. Reynolds American - Tobacco
7. Sara Lee - Foods
8. Southern - Utilities
9. UST - Tobacco
10. Verizon - Telecom
11. Bank of America - Bank/Financial
12. Citigroup - Bank/Financial

Although we can see some concentration, particularly in tobacco, most of these companies are in areas where there has traditionally been good dividend yields available, especially tobacco, banks, utilities, and telecoms. In general, given our insistence of a high dividend yield and the safety of large companies, this portfolio has fairly good diversification.

The point is here, that it's currently possible to construct a conservative portfolio that's initially close to cash-flow positive, after borrowing all the money to buy that portfolio. I'll talk about some other possibilities later ...

JW

The Confused Capitalist