SMSFundamentals: The Basics Of Portfolio Construction

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SMSFundamentals is an ongoing feature series dedicated to providing SMSF trustees with valuable news, investment ideas and services, in line with SMSF requirements and obligations.

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The story below was originally published as part of Weekly Insights on 21st October 2021. It is hereby re-published to highlight its importance through inclusion to the SMSFundamentals section.

The Basics Of Portfolio Construction

By Rudi Filapek-Vandyck, Editor FNArena

On my observation, the investment services industry is focused too much on providing the next hot tip and individual stock recommendation. Granted, there is obvious, natural demand for such 'information', but it is also my observation many an investment portfolio suffers from a lack of structure and/or a well-thought out strategy.

Hence, this week I am sharing my own thoughts and experiences with structuring and running an investment portfolio. May it help and assist those investors currently in the dark when it comes to defining a strategy and structuring their own longer-term oriented equities portfolio.

First up, I can report from personal experience, from the moment you are running a structured portfolio, you no longer are an investor in stocks. Just like a coach of a sporting team, you stop concentrating on each of your players individually. Instead, you start realising, and appreciating, the effort made as a team, though you never want to lose sight of the individual components, of course.

Putting a team together, which in this case equals a basket of stocks, starts with the realisation not all players on the field can be hot blooded race horses. The sun doesn't shine every day, all day and we must accommodate for four seasons that cannot be perfectly anticipated each and every time.

Hence we need some race horses, but equally a selection of sturdy, reliable muscle-machines that can pull a load when the weather is cold and the ground is wet and muddy. Apart from the occasional exception, a well-diversified selection means the portfolio never sees all stocks rallying or all falling on a given day, in particular not with share market momentum as polarised as it is this year.

As an added benefit: come the next period of share market weakness, we might feel less inclined to sell everything and hide under the bed.

All-Weather Portfolio

Focus and momentum for the share market changes regularly, and often occurs completely unexpectedly. Instead of constantly shedding and selecting new stocks in order to minimise our losses and avoid missing the boat, once we have that structured portfolio in place, we find ourselves in the role of the master coach overseeing the team, making smaller changes here, and a minor recalibration over there, in response to a changing outlook.

Before we find ourselves in such a position, we need a basic road map as to how we get there and where to get started. In my case, I started with my own research into All-Weather Performers; reliable, proven business models with a track record of performance, not hindered by economic cycles to generate shareholder wealth.

How many stocks should I choose?

Over the past years, I have come to the conclusion that 6% as a full weighting for any given stock is an excellent target. It implies when the portfolio is fully invested the basket contains between 16 and 20 stocks, on average. That's a reasonable number that can still be overseen and managed, assuming they're not all high risk fly-by-nighters that need to be watched constantly.

As part of portfolio management, decisions can be made to allocate half-weightings, or reduced weightings, and in some cases of high conviction an overweighted position, but I would refrain from allowing any position to become too small or too large. As far as the first option goes: it's okay to have a punt every now and then, but if it's not worth owning at a sizeable allocation, is it even worth the energy and attention, let alone the risk?

There is no universal golden rule about what maximum size should be allowed, but I'd be hesitant to allow any given allocation to grow beyond 9% of the total. The reason is simple: risk. Take profits if you must. Consider it part of portfolio management.

On the other hand: don't feel like you need to top up on allocations that haven't worked out and shrink in portfolio importance. Better to always ask that question: where is my money in the best of hands? As impregnated as we all are by this idea that 'cheaper' stocks perform better than those that have already outperformed, the most often made error is selling the winners too early and putting more money into the laggards and losers.

I can guarantee you all this will be the first of lessons that will be learned, time and again, through running an investment portfolio.

As per the lists on the website currently, my research has identified 21 All-Weather Stocks, of which some are still "potential" and others are carrying a question mark. Should we simply buy all of them?

That wouldn't be much of a diversified structuring, would it? All-Weather stocks are spread out over multiple segments and sectors, but most share the same basic characteristics, including above-average Price-Earnings (PE) multiples, which means they potentially can land in or out of favour all at the same time.

Equally important, most investors want income from their portfolio and All-Weathers, if only because of their valuation, are not ideal for short-term income purposes.

It is for this reason that I decided back in late 2014, when we launched the All-Weather Model Portfolio, that a selection of income providing equities would be the second pillar of the overall portfolio strategy. A third pillar consists of emerging new business models and technology disruptors by applying a quality assessment to the many newcomers on the ASX over the semi-decade past.

In practice this means I am combining the likes of Amcor ((AMC)), CSL ((CSL)), REA Group ((REA)), TechnologyOne ((TNE)) and Wesfarmers ((WES)) with higher dividend yielders Aventus Group ((AVN)), Super Retail ((SUL)) and Telstra ((TLS)), and with the younger businesses of NextDC ((NXT)), Pro Medicus ((PRO)) and Xero ((XRO)).

View From The Portfolio Control Room

For the sake of creating a starting point, let's assume we allocate 33% to each of the three pillars. Next things to do: team play, fine tuning and overall macro strategy. Do we lean more towards risk aversion? Can we be more aggressive with our risk-taking? Do individual valuations require profit-taking and trimming of positions? Is there an opportunity out there we'd like to include? Should the portfolio increase its cash allocation given market jitters?

All these questions, and many others, will pop up along the way but from now onwards you can address them through allocating more here and less over there. It goes without saying, to make such decisions requires we know the basics about the companies we own, and we can make a reasonable judgment about what is happening in markets. Neither fear nor hope has ever proved to be a successful strategy in the long run.

One extra benefit is we learn a lot about the companies we own. Always best to know what we own, and why. My own experience also tells me we must never consider our stock choices and portfolio allocations as set in stone. Ignore individual losses and gains. Always keep an eye on the future. Make decisions that seem right. And make those decisions for the team.

Not selling because you're sitting on an individual loss while all the evidence is telling you you should, is not smart team play.

But equally: accept your execution won't be perfect, and luck has its own role to play.

What About Income?

Equally important is that most of the companies in the All-Weather Model Portfolio pay a dividend, but that should never be the sole reason to include a stock. Taking a team approach, we should combine the 5% offered by Aventus with the sub-1% offered by CSL as well as the zero pay-out from Xero.

The average yield for the total basket is what counts. Forward looking estimates only. The All-Weather Model Portfolio on average yields between 2.5%-3%, which may not seem a lot given the banks are back yielding 4% and more, as is the ASX200 index, but that extra -1% missing in yield has been compensated through relative outperformance.

The portfolio can always sell a few extra shares if/when we need that extra bit of income.

You'd have noticed I don't try to have all main sectors of the market represented, which is equally a valid portfolio strategy. Neither do I use rather traditional definitions such as 'defensives' or 'blue chips', which I personally find outdated. AGL Energy ((AGL)) officially belongs to the defensives on the ASX. Have a look at that share price since 2017 and try not to shudder.

Size does matter, however, and smaller cap stocks come, on average, with higher risk and more volatility than larger caps. So this should be one extra consideration for the average, risk-conscious investor.

The Portfolio also has that added goal to prove to investors All-Weather Stocks are worth focusing on and investing in, so the selection of stocks tends not to include the banks when looking for dividends while cyclicals, being the anti-thesis of the All-Weathers, are simply not an option.

You Have Options

In the current context of potential concerns about sticky inflation and rising bond yields, a decision can be made to include a selection of banks, other financials and cyclicals (miners, energy producers, contractors and engineers, etc) and this would simply fit in with the portfolio strategy as described above: adjust relative allocation according to comfort/discomfort with the inflation outlook (to the best of your abilities).

In similar vein, with investor focus currently on re-opening beneficiaries, this too can be integrated in our portfolio and strategy. One warning though: make sure your portfolio doesn't get hooked into one (too) dominant theme as that makes all of the above redundant. Running a diversified portfolio is by definition an admission that we cannot accurately forecast and anticipate all events and momentum changes every single time. So, yes, we are at times giving up on more potential upside, while looking for compensation in different circumstances.

Besides, a number of companies currently in the All-Weather Model Portfolio stands to benefit enormously from re-opening borders and economies, even though they might not yet be seen as key beneficiaries by the majority of investors who prefer to crowd together in airlines, airports and leisure companies.

Sometimes the allocation to new trends and focuses occurs without actually having to make a change in the portfolio!

I know some among you like to take a punt, and many do it more than regularly. You can always put a decent portfolio together and include a special reservation for your more risky, short-term, adrenaline-filled adventures.

And if you're into ETFs instead of individual shares, or a combination of the two, that can be accommodated too.

If all of the above is genuinely new, I highly recommend adopting and applying the basic principles. It'll change your life as an investor, not to mention the additional skills and insights that come with it.

****

For more info about the FNArena/Vested Equities All-Weather Model Portfolio send an email to info@fnarena.com

Recent monthly portfolio reviews in 2021:

September

https://www.fnarena.com/downloadfile.php?p=w&n=B6798F75-0375-ACE0-CAB39BEDF04567BE

August

https://www.fnarena.com/downloadfile.php?p=w&n=B674AF06-E339-5816-5FD0DA4AE7D29F80

June/July

https://www.fnarena.com/downloadfile.php?p=w&n=B66CC435-9758-005C-77B2719A92612A9B

May

https://www.fnarena.com/downloadfile.php?p=w&n=B66804C2-BB83-93BF-AEFB5A28EC0E4A5A

April

https://www.fnarena.com/downloadfile.php?p=w&n=B664E73A-FBB4-1456-8EF79590D64EBF29

March

https://www.fnarena.com/downloadfile.php?p=w&n=B66218E0-DB14-B8D4-360E91AE22EA01AC

February

https://www.fnarena.com/downloadfile.php?p=w&n=B65DC629-929F-1743-8FF1EEFE600DF5A8

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