Now there is something to be said about having both stocks bonds. Typically, they do act in opposite directions which investors typically like because it gives less volatility. When rates go down, the stock market typically goes up because the risk-free rate is now lower and it’s relatively more attractive to buy stocks, and companies have cheaper debt financing.
If we look across the board, stocks and bonds in more developed countries are priced similar to each other, but with very different risk profiles.
So, before we talk about the current market situations, my message is really this: Learn how to value the asset classes and then determine how much exposure you would like to have.
- For the second presentation: The Intrinsic Value of Southwest Airlines, I will talk about your how to value specific stocks. Until then, I highly encourage you to check out this link with the free resource for a general valuation of the stock market you are in.
- In terms of valuing short term bonds, it’s very simple. At the time I’m doing this video, you can get 2.3%, from holding a 2-year bond that is the expected return. You hold close to no interest risk because the bond runs out in just two years.
- For long term bonds, it’s slightly more complicated. For instance, we talked about the 30-year bond at 3%. If the rate when up by just 1% – you would lose 17%. The math is not as complicated as it sounds. Check out this link if you want to look it up for yourself.
Current Market Conditions
- You can expect very low yields on your stocks if you buy the entire market.
- You can expect higher yields on individual stocks, but the short-term effects are the same as going down with the market is the same. Energy stocks only have a 25% correlation (and other exceptions).
- The yield you can get on long-term bonds are very low, and if you deduct inflation and taxes, you end up with around 0%. In Europe, likely lower than that.
- The yield on short-term bonds are not overly attractive, but you can keep up with inflation, and more importantly, you don’t have the risk of interest rates changes which gives accessible funds to invest in assets classes that suddenly has a more attractive valuation.
- If you are an income investor, I will not look at bonds but rather a basket of dividend stocks with a wide moat and little debt. I would cross-check what happened in 2008 and see if they made more money during the crisis and perhaps even increased dividend despite the company’s stock price being cut in half.
Number of Securities and Position Size
There are as many ways to construct your portfolio as there are investors. I would like to emphasize two questions that all investors have asked at some point in time of their investing career – and it’s a continuous struggle.
If we look away from ETF investing, which is different and you focus on individual picks, I would suggest that you have between 10-20 stocks. With more than 20 stocks, the gain of the extra diversification from owning, say, another 480 stocks is almost on existing. In other words, if you buy more than 20 stocks, you’ll likely pay more in commissions and trading expenses than you gain from the diversification. You can, of course, choose to buy an ETF, but what the ETF’s investors typically buy is market-weighted meaning that bigger companies are overrepresented. Apple would be almost 4% in the S&P500, but if you buy the biggest and more diversified ETFs, you would typically not need more than 2-3 as you also own the underlying securities. So, 10-20 is only for individual picks.
Also, you need to really understand the knots and bolts to pick individual stocks. So, if you own more than 20 stocks and have a watch list too, you’ll likely either have to do this for a living, or you would miss out on so much information that you can’t keep track.
Regardless, I wouldn’t suggest having more than 10% of my portfolio in the same stock. We must always be respectful of the possibility of being wrong. I’m as guilty as charged. Back in 2013, I had 27% of my position in National Oilwell Varco. I did my research and plowed through all the financial reports. I couldn’t see how I was wrong, and I made a sizeable bet. When the priced dropped, I sold out. It bottomed out almost 50% lower than what I bought it at. I could tell you ten reasons why I was right in my assessment, but the bottom line is: “I was wrong.”
Everyone is wrong from time to time. Though the best investors are not as often wrong as I am [haha]. So, I would never suggest anyone put more than 10% in the same stock. If you feel more comfortable with 5%. Then that should be your limit.
The next thing I would like to talk to you about is Volatility.
Generally, investors shy away from volatility, which is also why it’s a good sales argument that you should own, say, 500 different stocks though you’ll not gain anything regarding diversification as we just talked about. At this point, you own the market regarding volatility. In other words, if the market crashes by 30%, you will lose something to that effect. If it goes up, so will your stocks. But in the long run, your stocks will, of course, perform accordingly to your skills as a stock picker, but you will in the short term still get what is called the “systemic risk” which are the fluctuations of the stock market.
As a value investor, I feel that volatility is underappreciated. It should be seen as an opportunity to buy low and sell high. Of course, none of us likes to lose money, but if your stocks depreciate in prices and the intrinsic value stays the same which is so often the case – use it as an opportunity to buy more, or celebrate if the company is buying back stock. However, a lot of investors do not feel the same way and choose a different approach. That is completely okay.
I don’t think there is anything wrong with having a portfolio that minimizes the volatility as long as you are well aware of how that would change the expected return and downside of your strategy. You shouldn’t be using the stock market returns as your benchmark if your goal and risk profile have another focus.
The famous value investor Sanjay Bakshi has stated multiple times the argument for having “stress-adjusted-returns.” How do you get the highest expected return in the stock market with the least amount of stress and lack of good sleep? Many investors find that individual stock picking is not for them and choose an ETF strategy aiming at indexing and spending as little time as possible on their investment.
I hope this very first lesson on asset allocation in the portfolio review course series has shed light on what you’re missing, but also what you’re gaining dependent on your approach. I wish you the best of luck building your portfolio.
