Some thoughts on portfolio building and management (Part 1/2)
Building your portfolio from scratch - My experience
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This article is the first of two articles on portfolio building and portfolio management. The objective of this article is to guide you through my thought process when I started building my portfolio and to get you thinking on some topics before building yours. If you have already built your portfolio you can also read it just in case you change your mind on any particular topic.
What I want to clarify is that the aim of these articles is not to tell you what to do because you should do what works for you with the objective of building a portfolio you are comfortable with. Portfolio building and portfolio management are very personal and will (and must!) vary widely among investors.
Without further a do, let’s get started!
The first question any investor should ask himself before even starting to invest is:
“What objective am I pursuing with my investments?”
Investment objectives vary widely and can go from wanting another source of recurrent income to planning for retirement. Once this question gets answered then the next logical question you should ask yourself is:
“How should I build my portfolio?”
This question itself has many other questions embedded:
“How should I diversify among asset classes?”
If I want to hold individual stocks…
“What type of stocks should I own?”
“How many should I own?”
“How much should I allocate to each?”
“How should I buy into my holdings?”
I will try to guide you through the options available for these questions as well as my thought process answering each one of them. I will basically tell you what I do and what my take is on each of these topics.
“How should I diversify among asset classes?”
Many investors have a hard time deciding which asset classes they will allocate their capital to. The answer to this question may not be something static, in fact, it will probably vary during your investing journey. You may choose an asset allocation during your 20s and change it drastically once you get older as your objectives and your risk tolerance changes.
In my case it has slightly changed during the last years.
How it started…
During my first year investing I only held one index fund (SPY) to which I Dollar Cost Averaged (DCA) every month a fixed amount. This is as boring as investing gets although the ratio return/effort yields a high number. I then included another index fund (QQQ) although I lump-summed this one. If you want to do passive investing, this is the way to go. In fact, Warren Buffett argues that this is what the average investor should do:
"A low-cost index fund is the most sensible equity investment for the great majority of investors, by periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals."
…how it’s going
After about a year and a half only holding index funds I decided to sell part of these holdings and I started investing in individual stocks. Recently I also made the decision of holding a cash cushion of 10% (additional to my emergency fund) which will help me ride volatility with less psychological pressure. I never use this cash cushion unless the opportunity is obvious, for example Amazon trading at P/E of 10 in the next year, yeah, not happening. I consider myself to be fully invested if my cash cushion is equal to or below 10%. I periodically save a portion of my income that directly goes into cash.
My current portfolio is distributed in the following way (approximate values):
Index funds (S&P500 and NASDAQ): 25%
Individual stocks: 65%
Cash: 10%
As you can see I am fully invested and my exposure to equity is 90%, this graph illustrates why I chose equity:
You will hear from many people that you should buy bonds because rates are going up and now they give you an interest rate of 1.5% (hahaha) or that you should buy gold and silver because they are a great hedge against inflation but the truth is that since 1802 equities have been the most profitable asset class by a wide margin. If you are still thinking on investing in Bonds here is what Warren Buffett recently said about them:
“And bonds are not the place to be these days. Can you believe that the income recently available from a 10-year U.S. Treasury bond – the yield was 0.93% at yearend – had fallen 94% from the 15.8% yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.”
If I don’t see worthwhile opportunities in equities I just prefer to hold the cash and wait for them, they will eventually come, they always do.
From my experience, the process of deciding what asset classes to hold will be iterative and you should chose what best fits you. My allocation across asset classes may change in the future.
“What type of stocks should I hold?”
This is another important question and the answer is tied directly to 2 questions:
“What is my objective?”
“What is my risk exposure?”
What is my objective?
People invest for a variety of reasons that range from obtaining other sources of income to retiring earlier. If your objective is to have another source of regular income then you should invest in dividend stocks or bonds because growth stocks typically don’t pay dividends. On the other hand, if your objective is to retire early you should probably invest in growth stocks as they provide a higher upside potential than a typical dividend stock.
My objective is to retire early so I invest in growth stocks. The thing with dividends is that they are very tax inefficient as the company pays taxes on its earnings and later on you are taxed on the dividends you receive. It’s kind of a double taxation. Dividends should be given by established companies that have exhausted almost every growth opportunity. If a fairly new company that is growing fast suddenly starts paying out dividends I would take it as something bad as management may be out of ideas or the growth opportunity may be over.
“What is my risk exposure?”
This question is linked to the previous question and should complement it in some way. Before starting to invest you should know yourself as emotions are going to play a huge role in your future returns. Try to ask yourself these questions:
“Do I need the money in the next 3 - 5 years?”
This question seems stupid but it’s very important. My first recommendation to any friend that wants to start investing is to invest money that they think that they wont need in the next 3 - 5 years. Why? Simply because the stock market is quite safe if you invest in the long run but its unpredictable in the short run. If you need the money in the short run you may be forced to sell during a correction or a bear market.
“Would I be comfortable seeing my portfolio drop 30%?”
Again, seems like a silly or obvious question that is easier said than done. Many investors answer “Yes” but then react quite differently when it becomes a reality. This question should serve as a filter, if your answer is “No” then don’t invest in small cap or mid cap growth stocks as they are quite volatile. Dividend and value stocks are less volatile and the probability of a 30% drop is lower, but never 0.
After answering these two questions you should be in a point where you know what you want to get from investing and what you are willing to risk to achieve it which should help you identify what type of stocks you are comfortable holding. In my case, I invest money that I hope that I wont need in the next 10-15 years and I have a stomach for high volatility so I invest in mid-cap and large-cap growth stocks. I tend to shy away from small-caps because I see that execution risk is too high although there are many great small-cap investors.
“How many stocks should I own?”
I am still trying to answer this question myself. Many investors will tell you to diversify across many stocks and others will tell you to concentrate your portfolio but the reality is that both of these strategies can yield spectacular returns. If you want real life examples:
Warren Buffett holds 49 stocks
Bill Ackman holds 10 stocks
Both had great returns in 2020 and both are considered to be great investors.
This too is an iterative process. I started holding few stocks and I currently hold about 16 individual stocks, however I will probably start concentrating my portfolio to hold a number of stocks which I can stay up to date with (maybe 10). I honestly find impossible to follow 16 stocks while I work on my 9-5. If your case is the same as mine then you are probably better off selling your lower conviction stocks to concentrate in your highest conviction stocks. The idea is to distribute your eggs in baskets that you know very well.
My advice here is simple: hold the number of stocks that you feel is appropriate for you but don’t hold stocks that you can’t follow just for the sake of diversification. Take into account that you may have done proper due diligence on every stock you hold but the process of updating your views on these companies with every new public information release is quite time costly.
“How much should I allocate to each?”
Once you know more or less how many stocks you are going to hold in your portfolio you should also think about how much capital you will allocate to each of your positions. It’s obviously preferable to allocate more capital to high-conviction companies so that your portfolio (on a cost basis) clearly mirrors your conviction.
I personally don’t like to allocate more than 10% of my initial capital to any particular stock because, as much as I might like it, I may be wrong about the company and there are risks that you can’t control. If the company then performs really well I would start thinking on trimming the position around 25%-30% but I obviously would never sell it completely.
This matter is also very personal and many investors may be comfortable initially allocating a large portion of their portfolio to any particular stock (cost basis) or they may choose to impose no limits based on performance. Take a look at this segment from an article (thanks @iancassel for pointing it out!):
Bill Miller is famous for holding $AMZN for almost two decades and he has allowed this position to make up 83% of his portfolio in 2020. So as you can see this is something that varies widely between investors.
It’s a good exercise to see graphically what your capital allocation is (on a cost basis) and how your current portfolio looks like, this way you can see how stock weights are changing due to performance.
“How should I buy into my holdings?”
Once you have done proper due diligence on any given company you might decide that you want to buy shares of that company but… how should you buy into this position? Here you have four main choices in my opinion:
1. Buy into position in one go (i.e. Lump sum)
With this strategy you just buy the whole position in one go at a price that you feel is attractive.
I avoid buying into my positions in one go (regardless of the price) because I am focused in growth stocks which have a big amount of execution risk inherent to them. What might seem a bargain price may turn out to be quite expensive after the next Earnings Release.
2. Buy into the position in several fixed-amount purchases distributed through time (i.e. Dollar Cost Average)
The idea behind this strategy is to buy fixed amounts of the stock at regular and recurrent periods without looking at the price. This strategy has become affordable to almost everyone due to the existence of fractional shares in many brokerages.
This is how I buy my index funds. This is a great strategy to avoid buying in the worst moment. I would recommend spreading the purchases over several months. Statistically dollar cost average is less profitable than lump sum but it is also less risky.
3. Buy into the position in several purchases as your conviction increases
The idea behind this strategy is to add to your position as your conviction increases, even if the price is higher.
This is how I buy into my individual stocks. Investing in companies that have great growth stories ahead but that have yet to execute carries a big amount of execution risk and you may want to delay your purchases until you receive more information about how the company is executing. You should not be scared to buy stocks at a higher price than your cost basis (averaging up) as it makes total sense if:
There is more publicly available information about the company
Your conviction about the future growth of the company is higher
Take a look at this chart that Brian Feroldi (@BrianFeroldi) shared on Twitter:
Here I would also like to quote Kris (@FromValue): “Conviction is built over time.”
4. Buy into the position when price decreases (averaging down)
Many investors add to their positions as Mr. Market provides opportunities. I’m also guilty of doing this although I would only do it on my highest conviction companies. Averaging down on companies in which your conviction is not the highest and just because of the lower price is a very dangerous strategy as it may be fueled by hope rather than conviction. Many times you will be wrong about the company and the stock will plummet for a reason so don’t chase it down the hill.
Final word
This is the end of the first article I will be writing on my experience on portfolio allocation and portfolio management. Although my views will probably differ from yours I hope that this article was useful in some way.
I would like to summarize this article in one sentence:
The right answer for: “How should I build my portfolio?” is that there is no right or wrong answer.
Feel free to leave your thoughts in a comment and let me know if you like this kind of posts, all views are welcome!
Stay well!
Great article. I think it would be useful for readers were you to include your age and investment time horizon for added context.
Hi thanks for the amazing article, really detailed and can help a lot of new investors. The one thought I have is to beat the market you must hold winners, the more you hold the higher the chance. You either work in your process to find winners or you hold more to allow for poorer stock picking skills. So is the answer to hold more when you are starting out and concentrate over time as your skills develop? An additional question for you. How do you approach portfolio management when you no longer add new money to it versus portfolios when you add new money monthly?