Why I can afford mistakes (and maybe you can't)

During the global financial crisis (GFC) I did something that, in retrospect, was remarkably stupid. It was perhaps my most expensive, and most valuable, mistake.

Prior to the GFC, I owned a concentrated portfolio focused on three stocks: Flight Centre, Infomedia and junior oil explorer Roc Oil. The problem with such a concentrated portfolio is that you need to be right—one mistake can set you back years. Sadly, I wasn’t.

Roc Oil was a disaster for a host of reasons. I could have protected myself from it had I respected my capital and refrained from ‘investing’ too much in such a speculative situation. The portfolio limit that accompanies each detailed review is designed to help you intelligently diversify your portfolio and avoid such grievous errors. Certainly, it would have saved me from the calamity of Roc Oil.

But there's a difference. Back then, I was 32 years of age with perhaps 33 working years ahead of me (Can someone please pass him a glass of water?—Ed). That gives me plenty of time to recover. Assuming I don't have too many Roc Oil's over my investing career, in the end one won't make much difference. At such a tender age, my human capital (my capacity to earn) is far greater than my financial capital (asset base).

Members approaching retirement, or those already on the golf course, have no such luxury. For them, a mistake of this magnitude does permanent, lasting damage. Their financial capital may be far greater than mine, but their human capital (which determines their ability to recover from mistakes), is far less.

These are vastly different circumstances so a strict portfolio limit that applies to both doesn't make complete sense. While the tool is useful, it's also blunt. Portfolio allocation is therefore a different issue for each person that considers it. Generally, we stick to a conservative approach but that may not suit everyone.

So here are six rules to help you tailor our portfolio allocation limits to make them right for you.

1. Define your portfolio

Your portfolio consists of two types of capital. The first is human capital (you), the second risk capital (your assets). Human capital incorporates your future earnings while risk capital includes all your financial assets, such as your home, investment properties, cash and bonds, managed funds, stocks and gold.

Let’s consider two investors (their portfolios are shown in Table 1 and Table 2). Darryl is a 65-year old retiree, Kerry a marketing executive 30 years his junior. Darryl earns $250 a week helping a charity. His human capital, at least measured by earnings, is small. Having just retired, he will start drawing down his superannuation.

In contrast, Kerry earns $150,000 a year and is rapidly climbing the corporate ladder. She has oodles of human capital and, besides food and pampering her dog Gekko, Kerry’s living costs are minimal. She saves $50,000 per year and expects that amount to grow by $5,000 each year.

These are significant facts. With limited future earnings capacity, Darryl needs to preserve his capital and avoid big risks. Kerry on the other hand can be more adventurous because she has plenty of time and a growing income from which to recover from any mistakes. Her portfolio is therefore likely to be more orientated towards growth, Darryl’s towards income.

Key point: To make the best long-term decisions for your wealth, consider all of your assets, including your income capacity and time horizon.

2. Define your stock universe

Darryl is in the best of health so his superannuation and investments might need to last for another 25 years or more. He would also like to leave something behind for his charity. Darryl therefore follows our model Income portfolio studiously.

He’s also on a 0% tax rate so he mixes stable companies offering high, fully franked dividend yields, such as Woolworths (4.6%) and Metcash (7.0%), with niche stocks such as essential infrastructure owner Spark Infrastructure and Sydney Airport.

These stocks are virtual monopolies offering a mix of growth, inflation protection and attractive unfranked distributions, although he recently sold Spark for reasons explained in Selling Spark Infrastructure on 20 Apr 12.

Kerry follows the model Growth portfolio because she doesn’t plan on accessing her investment funds for decades so she can stomach higher volatility. As a keen value investor, Kerry has trained herself to use falls in the market to put her regular savings to work in cheap stocks.

Kerry’s blue chip shareholdings from our current Buy list include QBE Insurance, Macquarie Group, Sydney Airport, Computershare, Origin Energy and Brickworks. Although they are Hold recommendations, Kerry also hopes to add to her holdings in high quality growth stocks including CSL, ARB Corporation,Cochlear, Newscorp and Platinum Asset Management at lower prices (see Fear: The comeback).

Kerry decided to avoid resources and speculative stocks due to their unpredictability but owns smaller companies from our current buy list including Fisher & Paykel Healthcare, Servcorp, Challenger Infrastructure Fund and WHK Group.

Like Darryl, Kerry owns Woolworths and Metcash. Even though their rapid earnings growth over the past decade won’t be repeated, Kerry reinvests the dividends into the best opportunities she can find. She knows the secret to accumulating wealth is to reinvest at high rates of return and let the ‘magic’ of compound interest do its work.

Kerry applies the same approach to her do-it-yourself superannuation fund. Online superannuation fund administrators such as esuper charge $699 per year to audit the fund—less than 1% of Kerry’s balance.

As an experienced value investor, she believes keeping her costs low and investing in a relatively concentrated portfolio of cheap stocks will grow her retirement funds much faster than if she remained in the super fund recommended by her employer.

Key point: Focus on stocks suited to your investing psychology and personal financial goals.

3. Set appropriate portfolio limits

Darryl is a conservative investor and tends to have a much lower percentage of his portfolio invested in the stockmarket than Kerry. Darryl usually sticks to blue chip companies and uses smaller portfolio allocations (while a retiree shouldn’t generally have 27% of his stock portfolio invested in one stock, as Darryl does with Woolworths, the dollar amount is dwarfed by his very conservative cash and fixed interest holdings). This minimises the risk of one bad decision and reduces overall volatility. Kerry, with many years of work ahead of her and plenty of cash coming in, knows she has the time and income to recover from mistakes.

Darryl has 9% of his total portfolio invested in Woolworths (5%) and Metcash (4%). The predictability of these companies means that should be okay (indeed, Intelligent Investor are likely to revise the recommended portfolio limits of 5% for these two stocks upwards shortly).

Darryl’s stake has grown over a long period, but he’d sell down if Woolies constituted more than 7% of his portfolio. Having read Nassim Taleb’s books The Black Swan and Fooled by Randomness, he understands that even the best businesses can perform poorly for a variety of reasons.

No company is invincible and, as US investors have found out the hard way over the past 13 years, buying the best companies produces poor returns if you pay too much. He’s happier keeping his overall portfolio limit at around 7%.

Darryl also avoids healthcare stocks such as Cochlear, ResMed and CSL. Their respective industries can change quickly, and the companies within it typically rely on one type of product and the stocks trade on high valuations. Darryl also avoids insurance companies such as Insurance Australia Group because of their vulnerability to unfavourable black swan (unforeseeable) events.

In stark contrast, Kerry has 10% of her total portfolio invested in QBE Insurance. She considers it cheap and is prepared to take a long term view. In a year’s time, her additional savings will mean the company will naturally shrink back toward our recommended portfolio limit of 7%.

Kerry prefers to concentrate her portfolio in her best ideas. Sometimes that means having higher portfolio limits than we recommend but she’s willing to accept greater volatility as a price for that. For Kerry, the destination is more important than the bumps in the road.

Key point: Our portfolio limits are a guide only. You can (and perhaps should) diverge from them for justifiable reasons.

4. Check for correlated risks

Just because you’ve selected a variety of different stocks doesn’t mean your portfolio is insulated from large, common risks. The GFC showed how heavily indebted companies reliant on capital markets for continued access to funds suffered.

Darryl and Kerry obsessively search for ‘correlated’ risks in their portfolios. They look for stocks that share common industries, common funding sources, common currencies and share a reliance on consumer spending, Chinese capital expenditure, oil prices and so on.

This task is more complex than it initially appears. Think of the companies that would be most affected by a housing downturn, for example: The banks, especially Commonwealth Bank and Westpac, property developers such as Sunland Group, Brickworks, Washington H. Soul Pattinson and so on.

Darryl’s portfolio, which includes two banks, Westfield Group, his own home and an investment property is more exposed to a housing downturn than Kerry’s, which is directly exposed through QBE Insurance (their PMI operation underwrites 40% of Australia’s mortgage reinsurance market), Brickworks and a small share in an investment property.

Then there are the second order effects. A-REITs like Westfield Group would suffer vacancies as the economy falls into recession. Lower consumer spending would impact retailers, including Woolworths and Metcash.

That’s why we’re so concerned about Australia’s high debt levels, reliance on China and high housing prices. As we’ve seen around the world, a genuine housing crisis is pervasive and leaves few companies untouched. That’s one reason why healthcare companies such as CSL and Cochlear are considered havens in a recession and still tend to trade at high prices.

To help avoid correlated risks, we recommend keeping your investments in the banking (including income securities issued by banks), insurance and funds management sectors to 10% each, and no more than 25% in total.

Key point: Owning lots of stocks doesn’t necessarily produce a robust, diversified portfolio. You need to look for correlated risks across a range of companies.

5. Consider international diversification

Diversifying overseas can be an efficient way to reduce risk, assuming you remember the golden rule to only ever buy underpriced securities. You can buy stocks listed overseas or buy Australian-listed stocks with overseas businesses (like QBE Insurance, Computershare, Macquarie Group and Fisher & Paykel Healthcare, all currently on our Buy list). Then there are the ETFs and managed funds, as discussed in A world of opportunity: Your overseas survival guide.

We’re also working on a special report filled with overseas opportunities, including five reliable stocks at which you can take a large swing. With the Aussie dollar currently falling, now could be a good time to open a foreign brokerage account (we’ll discuss two more brokerage options in the special report) and buy some US dollars in preparation.

The downside for Darryl is that overseas stocks often have paltry dividend yields and don’t offer franking benefits, although you can usually claim back withholding tax.

Key point: Overseas diversification is easy to achieve. Right now is an unusually good opportunity to buy high quality overseas stocks while the Aussie dollar is still high by historical standards.

6. Examine your attitude to cash

If you want cash for living expenses, set it aside and exclude it from your portfolio. Colleague Gareth Brown recently explained why he holds cash in The case for cash. As he suggests, it’s a personal decision.

As her savings keep increasing each month, Kerry doesn’t need to hold much cash. Alternatively, if she is waiting for outright Buy recommendations that should offer high returns, then she may hold large amounts of cash from time to time. Indeed, in anticipation of future bargains our model portfolios have rarely held as much cash as they do currently.

Over the long-term cash is a poor store of value so it should be put to work when opportunities arise, as they did in 2008/2009 and August last year (see Chaos amid the storm: The upgrades). Keep in mind that Australian interest rates could fall further, so don’t expect cash to fund a long retirement.

Key point: The value of cash is in the future investment opportunities it can secure, not as a store of value.

Summary  

Diversification isn’t only about the number of stocks you hold. If you own 10 deeply undervalued securities and add 10 more, it increases the odds that you’ll eventually enjoy a pleasant outcome. But if you own a portfolio of 10 horribly overpriced securities and add 10 more, it actually increases the likelihood of a poor outcome.

Diversification reduces the role of luck, but that doesn't mean it always reduces risk. Diversification won’t save you if you’re not buying cheap stocks, which is why valuation always matters. Nor will it save you if your portfolio is loaded with correlated risks.

Here’s four quick tips for successful portfolio management that you can put into action now.

1. Large portfolios become unruly and don't offer much additional diversification. Limit yourself to around 20 stocks.
2. It might take years to build your desired portfolio so be prepared to hold cash and don’t become impatient. Wait to buy the businesses you admire at attractive prices.
3. Focus on your best ideas (i.e. cheapest stocks). You might invest larger amounts than we recommend for the reasons discussed above.
4. There's nothing wrong with holding cash but don’t hold large amounts over long periods because inflation will likely erode its value. Nor should cash burn a hole in your pocket; it offers better protection than overpriced stocks. Good buying opportunities invariably arise so don't invest in average ones just because you have the cash to do so.