You will be able to set how much of your portfolio goes to stock picks and say why the rest stays in index funds.
Before you read on, open your investment workbook and total two groups of holdings: your index funds and your individual stocks. Record each group as a dollar amount and as a percentage of the whole portfolio. Those two pairs of numbers are your starting point, and every later step depends on them.
You have now finished eleven modules. You can read an annual report, build a model, value a company and size a position. With those skills in hand, most people want to pick more stocks and move more of their money into them. Look at your own numbers before you do. Having the skills is one thing. Having evidence that they earned you extra return is another, and the amount you put in your own picks should rest on the evidence.
Module 12 assembles the whole portfolio, adds up what it costs you to run, and sets the result honestly beside a managed alternative. The first piece is core and satellite, the structure most professionals use when they hold their own stock picks next to index funds.
In a core and satellite portfolio, your money sits in two parts. The core is a group of low-cost index funds. It holds most of the money and supplies most of the long-term growth. The satellite is the smaller part, where individual stocks and any other active choices go.
The core follows your allocation, meaning your split between shares, bonds and cash. You worked that split out in lesson 1.3, "Set your split from horizon, need and nerve", in the Build and run an ETF portfolio course, and recorded it in your policy in lesson 8.1, "What goes in an investment policy statement". It is not repeated here. Pull the allocation and the benchmark straight from your investment policy, then fill the core with low-cost index funds that match. Every individual stock, and every other active choice, belongs in the satellite.
Marcus (a course persona; all his figures are invented examples) has done the same eleven modules as you and has the same skills. His allocation of 80% shares and 20% bonds and cash, and his blended benchmark, both come from the Build and run an ETF portfolio course. Right now his core is worth S$151,000, about 75% of his portfolio, spread across a world ETF, an STI ETF, an SGD bond fund and T-bills. His satellite is worth S$51,000, about 25%, in four single stocks: the bank, the chip designer, the S-REIT and Larkspur.
A satellite needs a cap for the reason any single stock does. Stock picks can lag for years at a stretch, and when they are a big slice of the portfolio, one poor run can shift your whole retirement plan.
Take a satellite that falls 5 points a year behind the core for five years (made-up figures). For a handful of stocks, a run like that is bad but not unusual. If the satellite is 20% of the portfolio, the drag on the total is about 1 point a year. At 50%, the drag is about 2.5 points a year, and after five years of compounding the shortfall is roughly an eighth of the portfolio's value. A large core is what lets you get through a long poor stretch for your picks.
The cap also puts a limit on your time. Funds need only a few hours a year, and almost all the rest of your investing time goes into stocks. Marcus fits that pattern: his four stocks take up most of his investing hours. Lesson 12.5, "Price your hours: what your research time costs", puts a dollar value on those hours.
It is tempting to size the satellite by how sure you feel about your picks. Size it instead by what your record supports. Compare four measures with your benchmark: time-weighted return, money-weighted return, volatility and Sharpe ratio.
Marcus reads his returns from his returns tab, built in lesson 1.8, "Build the returns tab of your investment workbook", and his risk measures from the dashboard he built in lesson 2.8, "Build a risk dashboard for your portfolio and two benchmarks". He looks at the record first and leaves his hours for later.
Over five years his time-weighted return is about 5.58% a year, against 5.43% for the benchmark, so he is ahead by about 0.15 points. His money-weighted return is about 5.16%; had the same deposits gone into the benchmark, they would have earned about 5.35%. Over ten years his volatility is 11.3% and the benchmark's is 10.0%. His Sharpe ratio is 0.37 and the benchmark's is 0.41. Taken together, he carried more risk and got no reward for it.
A record for the whole portfolio can't show that the stocks added nothing. A weak one, though, offers no evidence that they added much. When your record shows no clear edge, keep the satellite no bigger than the total your module 11 single-stock rules already permit.
Marcus totals his module 11 targets: 5% for the bank, 5% for the S-REIT and 4% for each of the two volatile chip stocks, which comes to 18%. The satellite becomes 18% and the core takes the remaining 82%.
Cutting the satellite lowers your share exposure unless you adjust the core, so rebalance the core to keep the overall share allocation where it was. Marcus moves his core to 52% in the world ETF, 10% in the STI ETF, 15% in the bond fund and 5% in T-bills, a total of 82%. Shares remain at 80% of the whole portfolio (52% plus 10% in the core, and 18% in the satellite stocks), and bonds and cash remain at 20%.
Let the satellite size follow the evidence up as well as down, and decide in advance how it will move. An investor with no rule tends to enlarge the satellite after a lucky year and find reasons to keep it after an unlucky one.
Your rule needs three parts: the result that cuts the cap, the result that allows it to rise, and a ceiling it can never pass. Set the bar for raising the cap high on purpose. Lesson 12.5 shows that once your hours are priced in, a satellite has to beat its benchmark by a wide margin to cover them.
Marcus begins with a cap of 18%. Once a year he compares his three-year time-weighted return, after all money costs, with the benchmark:
Behind the benchmark: the cap drops by 5 points. Ahead of the benchmark by more than the yearly value of his investing hours, measured as a share of the portfolio: the cap may go up by 5 points. Whatever happens, the cap stays at or below 25%.
Before you write your own split, gather your returns tab and risk dashboard, and the sizes your module 11 rules allow for each of your stocks.
Write down your core and satellite split and your reason for it. Then write the measured result that would make you shrink the satellite.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).