My Rules For Portfolio Strategy
Summary The list of rules below comes from my personal investing experience. By preparing a set of rules in advance investors can be ready to make better decisions. A major change in my personal views is the inclusion of a rule to not be scared of sitting on cash. When a high quality ETF drops in price I view the drop as a sale, but when a company is trading down on good cause, I’m less attracted to it. Lately I’ve been finding more and more messages coming to my inbox. It’s great to hear what my readers are thinking, however I’ve noticed a trend in reader messages. Since I frequently cover the mREIT sector, readers want to know about how attractive the sector is as a whole and how I’m modifying my holdings and my portfolio strategy. This is a great area for research and it is an area that has been on my mind quite a bit lately. Therefore, I’ve come to a few rules for portfolio strategy that I believe will help me avoid mistakes and that I think readers will want to consider in designing their own portfolio strategy. Rule #1 Contemplate your portfolio goals before deciding how your money should be allocated. Frequently we here that all investors really care about is “total return”. I’m not saying that the source of return is a huge factor, but the volatility of the returns is a meaningful factor. In seeking risk adjusted returns I think investors often forget that the returns need to be measured on the basis of the risk involved in achieving them. Rule #2 All volatility is not created equal. I expect to see some volatility in my portfolio but the cause of the volatility matters. When my holdings fluctuate with the values on the major indexes it does not bother me as much as when individual holdings are moving dramatically. When Freeport-McMoRan (NYSE: FCX ) plummets on weak demand for commodities and commodity futures take a nose div, it bothers me more than when shares of the Schwab U.S. REIT ETF (NYSEARCA: SCHH ) drop on interest rate movements. This is a purely human response. I have a very strong level of faith in the future of equity REIT indexes, but I don’t have that same level of faith in commodity pricing. If someone asked me about the difference in these scenarios even a year ago, I might have had a different answer. I might have said that the volatility at the portfolio level was what mattered. Under “Modern Portfolio Theory” it would be precisely correct to focus only on the volatility at the portfolio level. However, the simple facts remain. When SCHH drops significantly, I see the low price precisely the same way I would view a discounted price at the grocery store. It looks like a sale and I toss more of it into my basket (portfolio). Rule #3 Focus on what you know. I discovered that the mREIT sector was a great fit for me because I enjoy math and prefer the harder sciences to the softer sciences. The construction of mREIT portfolios as leveraged option-embedded bond funds fits in precisely with how I like to do research. For many investors the mREIT sector is simply too dangerous for involvement and those investors should follow their allocation rules rather than go chasing yield. Rule #4 Index what you don’t know. There are thousands of investable equity securities in the U.S. market. It would be impossible for a single investor to know enough to be competent on every single security. Being truly competent (rather than merely arrogant) on a sector requires an intense time commitment. Only investing in that sector though would create a great deal of risk for the portfolio. Therefore, I believe the core of the portfolio should be held in funds that track a diversified portion of the equity market. For instance, I’m long the Vanguard Total Stock Market ETF (NYSEARCA: VTI ) as a major holding in my portfolio. I want to complement my indexing strategies with buying the most attractive options. This rule should not be construed as saying that if you don’t know “Chinese Solar Stocks” you should buy an index to represent them. If you don’t know that part of the market and it is not highly relevant to your investing strategy, then it should be avoided entirely. The goal with this rule is simply to fill in the desired allocations with low fee index funds to reduce the volatility. Rule #5 Don’t be scared of cash. I’ve been guilty of allocating my cash to equity rapidly on the basis that cash earns very poor returns when interest rates are very low. This becomes a situational issue. If we are talking about an employer sponsored 401k plan, it makes sense to pick the appropriate allocations (which would usually be low on cash) and to just “set it and forget it”. Since these accounts are using dollar cost averaging this can be a great strategy so long as the 401k plan has at least a couple excellent options. For instance, I’m using the Fidelity Spartan Total Market Index Fund (MUTF: FSTVX ) and the Fidelity Spartan Real Estate Index Fund (MUTF: FSRVX ) in an employer sponsored account. They have an enormous overlap with some of my other holdings, but when it comes to a passive account using dollar cost averaging I simply want a diversified U.S. market fund and a diversified U.S. REIT index fund. In both cases I care a great deal about expense ratios which were huge factors in picking the funds I did for that account. When I’m adding to my other holdings which are going to be more actively managed, I’ve revised my strategy to be more willing to hold cash. I’ll hold onto the cash until I find very attractive opportunities. One example of this scenario is being willing to pass on attractive opportunities when there may be even better opportunities right around the corner. Missing out on a good investment is an acceptable tradeoff for me if the discipline also keeps me from making bad investments. Rule #6 Define attractive opportunities. This builds upon the rule of not being scared to hold cash. If the goal in holding cash is to have some dry powder to load up on the investments that appear to be on sale, then you should know in advance what you consider to be a sale. For instance, I consider shares of SCHH at about $36.00 to be on sale. If shares of SCHH drop under $36.00 then I will happily spend my cash on buying more. I am perfectly willing to be overweight on the equity REIT sector despite the interest rate sensitivity because I have such a strong belief in the underlying fundamentals. I am also willing to buy up mREITs when I see them trading at what I consider to be a material discount to the market leaders. I generally view Annaly Capital Management (NYSE: NLY ) and American Capital Agency Corp. (NASDAQ: AGNC ) as the big players in the sector and I view other mREITs in relation to those companies. Due to the sheer size of NLY and AGNC, I believe the market will usually be more efficient in pricing them than in pricing the smaller players. Since I view mREITs on the basis of relative attractiveness, NLY and AGNC will usually be rated near hold in my view. The smaller mREITs can range from “strong buy” down to “short” based on their prices relative to the big players and their sustainable level of dividends. I may occasionally see AGNC or NLY as a very attractive company to go long or short as part of a pair trade. In those cases I’m seeing an attractive opportunity based off the other mREIT in the trade being too expensive or too cheap and I see the offsetting position in AGNC or NLY as an effective hedge to make the position market neutral so the investor is strictly seeking the alpha from correcting the pricing differences between the two mREITs. Conclusion The times when I’ve got burned the worst on a trade are precisely the times that I violated these fundamental rules. Each investor should know their own boundaries before selecting securities and they should remember that the rules they make are there to protect them. Those are the rules I attempt to follow in handling my investments. What rules do you follow in yours? Disclosure: I am/we are long VTI, SCHH, FSRVX, FSTVX, FCX. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.
