Allocation and the Zoom Lens
It is commonly thought that investing is about picking the right stocks. Not so. Research has repeatedly shown that allocation is the primary determinate of returns.
Allocation is about dividing investments into buckets or categories to achieve balance.
Most investors in groups I lead want to talk about winning stocks, and their stories. I call them bottoms-up investors. They buy individual securities that have appeal. The end result may not at all be balanced.
Allocation is about starting top down, and then using a zoom lens to focus up and down the categories to assure proper balance. A given level, such as a portfolio, may have multiple dimensions, such as large cap-small cap, growth-value, domestic-international.
I monitor the cash accumulating in each account, and when it is enough to buy more positions, I analyze for each client the current balance compared to the allocation we agreed upon or which I presume optimal based on their goals.
Our Logo Hierarchy
In our logo hierarchy, we start at the top with everything I manage. In my pivot table, that can be subdivided in several ways, such as by client, by the various accounts held by each client, by goal, etc.
In the logo I show a division by size of the market capitalization.
After many years, I have discovered that I have a competitive advantage in micro-cap stocks (market cap in range of 250m), both debt and equity, that do not have enough stocks trading (liquidity) for the funds and institutional investors to be competitors. If it takes two or three days to buy or sell a $10,000 position, I can do that by adjusting the limit orders for a stock that is not very liquid.
For selling a house two days would be considered liquid. Liquidity is important if one does a lot of trading based on price fluctuations. It is not important for longer-term investing.
I think liquidity is the primary reason we can have fixed predetermined income of 10% annually with preferred stocks while the bonds being traded by funds and institutional investors might be at 4%. If you look at compounding the difference, the variance becomes significant. With a 4% return and 3% inflation, that is a real return of 1%. Compare that to a real return of 9%!
Income vs Price
Goal is the middle level of our logo hierarchy. Assuming a goal of increasing valuations, the investor can buy low and sell higher for a profit, referred to as gains. Receiving income is the other avenue for profits. Established companies may pay a 3% dividend and the investor is looking for both income and gains. I find that conflating income and gains results in diffusing the focus and lower overall returns. If I can't beat the indexes, I don't have a business. While investment software is not very accommodating, I report income and gains separately.
Income is like "a bird in the hand is worth two in the bush". Fixed income, by definition, is fixed and not volatile. Gains are hypothetical. Unrealized gains is what you have if you had sold on the date of the report. But most often we didn't sell and we don't know what the price will be when we choose to sell and realize the gains (or losses).
Our income exceeds the gains of the stock market over the past hundred years. And we don't have to worry about price fluctuation or try to predict the unpredictable.
Overall Allocation
Income can be divided between fixed income, such as preferred stocks and notes, and other high-yielding stocks such as REITs, Business Development Corporations (BDC's) and Closed End Funds (CEF's). The latter have higher dividends, in the 12% to 14% range, but can vary with changes in company profitability. The stocks in the Other High-Yielding category are equity, although their businesses are mostly dependent upon managing debt.
Increasingly I have clients asking me to manage just their their income (bond) allocation. We generally put 80% in preferred stocks and notes and 20% in Other High-Yielding Stocks.
Where I manage most all of the investments for younger clients, a typical allocation will be 50% preferred stocks, 20% other high-yielding stocks, and 25% having a goal of price appreciation. The latter category consists of portfolios such as micro-cap equities, emerging market funds, and commodities. That leaves 5% or less for accumulating cash.
For more about how preferred stocks work, and how they are debt rather than equity, see the menu item Preferred Stocks.
Portfolios
For me, rarely does a stock stand alone. Every stock is in a portfolio with similar stocks based on some common criteria. I'm more interested in the performance of the portfolio than of any single stock. Portfolios generally have between seven and twenty positions.
Under the goal of Fixed Income I have three portfolios:
1. Preferred stocks issued by REITs,
2. Other preferred stocks, and
3. Notes.
Notes are like goats and sheep in the same pen. The only difference with a note, sometimes called a baby bond, is that it has a maturity date when we know out investment will come back to us at $25 per share.