Tuesday, February 08, 2005

Asset Allocation and Portfolio Management: An 80-20 Super-Rule

Back to our example of how to allocate $1 million, here are some basic asset allocation and porfolio management rules I use:

1. Diversification: Invest about 5% of the portfolio in each of 20 assets (stocks or properties), but not many more than this number, for that would not allow the degree of focus needed to manage the individual positions well. When very bullish about long-term fundamentals of a company and timing, double the exposure to 10%. When prospects are sound but timing is less certain, start with half exposure of 2.5%, leaving open the possibility of buying more later.

2. Concentration: Allow winners to run but cap exposure to any one asset at 20% (4 x 5%) of the portfolio. Also, give losers time to recover but, if the value of an asset drops to 1.25% (1/4 x 5%) of the portfolio, either buy more if still bullish or sell the position and move on. Furthermore, to avoid having too many highly correlated assets, limit exposure within a single industry to about 30% or 40% of the portfolio.

3. Fundamental Soundness: Invest only in companies that are very likely to be around in 10 years. Typically this means market leaders with strong balance sheets (little to no debt, making them effectively bankruptcy-proof), top (revenue) and bottom (profit) lines that have been growing consistently for at least five years, strong profit margins, and positive cash flow generation. Instead of buying IPOs, allow at least a year of public market trading history to develop post-IPO before buying into any newbie company.

4. Familiarity: Invest in "familiar" industries and companies, i.e., those that you normally tend to follow in your everyday walk of life, through work, hobbies, friends, or whatever information source. Frequent exposure to relevant information gives you a slight edge over people who are further removed from the news and events affecting an industry or company.

5. Equities: To take advantage of long-run secular trends pointing to outperformance of equities, aim to stay fully invested. Generally, regardless of the condition of the overall market, it is possible to find 20 assets (stocks or properties) that have very attractive upside-downside ratios and warrant deployment of investment capital.

6. Relative Value: Make buy and sell decisions based on relative value analysis, trading out of positions with diminished upside and into new positions with better upside-downside ratios. "Reversion to the mean"-style thinking comes into play here, with statistical outliers often showing tell-tale signs of undervalued and overvalued assets. I find PEG to be a very useful indicator for identifying good relative value.

7. Portfolio Turnover: Buy with the intention of holding any particular asset for 10 years; however, be prepared to sell if fundamentals turn negative. This leads to an expected average turnover rate of 10% annually. Allow turnover to fluctuate in a range from about 5% to 20%, depending on opportunities that present themselves.

8. Target Returns: Target a 20% annual return, buying assets that might deliver 40% with flawless execution on the part of management and a little good luck, and that truly can be expected to return 10% even with a few hiccups and some bad luck along the way.

9. Hope and Safety: Make sure that within the portfolio there is a good mixture of assets, some of which should safely deliver 10% returns and others which hopefully might even double in a year. In investing, as in life, we all need a healthy balance of hope and safety.

10. Simplicity: As an investor, spend the bulk of your time gathering information to give yourself an edge over others. Avoid holding assets that require large amounts of time and effort to be spent on day-to-day management duties (after all, that's what we do as workers, not as investors!). Keep transactions simple (e.g., through stock investing) to allow more time to be focussed where it can be utilized most productively, i.e., in making the most informed and best possible buy-sell decisions.

These basic rules are aimed at creating a "perpetual portfolio" with high (20% annual) and consistent (80% confidence) returns. Taken together, the individual rules comprise an "80-20 super-rule" for optimizing investment performance and allowing our hypothetical $1 million portfolio to grow indefinitely.

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