One way to find gold is to pan for it. You take the silt and sand from the bottom of a river, usually up in the mountains where gold seems are exposed, and you scoop it up in a pan. Then you swirl the material around until the heaviest particles (usually gold) separate from the other materials. You can then extract the gold from the pan in its purified form.
You could just load up all the sand and silt and take it off to the mill to be processed. But that would be very expensive and wouldn’t produce what you were really after, pure gold, very easily.
Building an investment portfolio requires a similar process. Somehow, we must refine or filter the approximately 43,000 globally publicly listed securities down to an investment strategy that best meets our financial goals (If you included non-traded investments the number of choices is astronomical so let’s decide to stick with listed securities because they are liquid and subject to constant market scrutiny). Each investor is unique.
Each investment situation is unique. So we must have a framework of decisions to winnow down the global investment market to suit us.
Just like hauling off all of the river sand, we could buy all global stocks fairly easily and cheaply using a global index fund or three. That’s actually not a bad portfolio.
You’d have maximum diversification, which is generally a good thing, and fairly low costs. Just like our gold speculator, however, you as an individual might have some needs and preferences that would benefit from eliminating some of these global investments in exchange for different portfolio characteristics. You’d be trading less diversification for some benefits.
Let’s talk about some of those trade-offs.
The first and probably most important one would be your ratio of stocks to bonds. The global portfolio is bond heavy. You’d be about 60% bonds which might not be the best idea if you were say, a 25-year-old investing for retirement. If that were you, you’d probably prefer little if any bonds in your portfolio because you would not need the safety bonds provided. Retirement is far off in the future and youth is the time to take smart risk.
So, eliminating stocks or bonds from the “buy everything” approach is first. Delete bonds for more risk, delete stocks for less risk.
What if you wanted higher expected returns for your stocks? Well, there are some things we know about stocks that can help us increase expected returns in your portfolio.
Risk is always related to return. So, how can we favor companies that are riskier individually but, via diversification, aren’t too risky for us as investors?
Small companies have higher expected returns than big ones. Why? Risk. Small companies fail more often so investors require more returns to invest in them.
Value (or struggling) companies have higher expected returns than growth (or great) companies. Huh? You are saying that struggling companies like Kmart have higher expected returns than Amazon? Yes, because risk is related to return and Kmart is riskier (They are flirting with bankruptcy).
One more screen we might use for stocks is profitability. It turns out that the most profitable firms today tend to generate the highest expected returns in the future.
Here’s an example of how this might help you. If you invested in the stock market in 1973 your dollar grew to $80 by 2011. Using just two of these screens, value, and profitability, your dollar grew to $572 over the same period. So, in this case, less diversification is a very powerful tool.
Now, for the bond side of your investment portfolio. Bonds are not a great source of risk-adjusted returns. As bond maturities go up, so does return, but not nearly as much as risk. Bonds become very price volatile as they respond to changes in interest rates. Let’s invest in short-term bonds only (5 years or less) and let’s buy longer-term bonds only when the interest rate they offer is significantly higher (A steep yield curve).
Bonds also pay investors for taking the underlying risk of the company. Really risky bonds (junk bonds) don’t offer a return commensurate with their risk. So let’s buy investment quality bonds only. And, let’s only buy lower quality bonds when we are offered significantly more return (This is called high credit spreads).
So, generally, we see bonds as a source of safety, not as a great source of real returns. Let’s buy only short-term, high-quality bonds to stabilize the portfolio in good times and get our long-term returns from stocks.
Now I have a stock portfolio that’s smaller, cheaper, and more profitable than the market. I have a bond portfolio that’s shorter term, and higher quality than the market. I also have a mix of stocks to bonds that is right for my life stage.
What about values?
Is it important that my investments match my values? Should I avoid or reduce my investments in companies whose ethical behavior is not aligned with my own? Are the companies I’m investing in aligned with me on the environment, social justice, politics, religion, healthcare, animal welfare, gambling, smoking, abortion, pornography, drugs and alcohol, and family?
If not, you may wish to eliminate, or reduce investment, in companies that don’t line up with your values.
So, now I have a smaller, cheaper, more profitable stock portfolio to give me higher expected returns. I have a shorter-term, higher-quality bond portfolio to stabilize my account during the tough market conditions. And, I’m investing in companies whose values align with my own.
By using a filtering princess akin to gold panning, you’ve improved your expected investment experience considerably by giving up some diversification in exchange for portfolio characteristics more aligned with your needs and preferences.
