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A Smart Portfolio Strategy for the Intelligent Value Investor

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

If you want to beat the market and get consistent returns over time, diversification across industries is key.

If you want to beat the market and get consistent returns over time, diversification across industries is key.

Zooming Out

If you're a value investor who has been investing in individual stocks for a few years, you've probably acquired a sizeable portfolio of businesses you think will perform well over the long term. You may have sold some stocks as they've increased in value. You've likely tended to your garden of stocks, pruning the weeds (the businesses Mr. Market is selling for a great deal more than you think they're worth) whenever they grow out of control.

Hopefully, you're starting to feel comfortable with your process for buying and selling on an individual stock basis. Now it's time to think about the bigger picture. What your overall portfolio looks like can help you determine which stocks to buy or sell next.

What follows is a three-step process that represents a very practical framework you can apply to your own investing strategy to help you determine what to be on the lookout for and when to do some helpful pruning. By looking at the big picture and using this view to help guide your micro decisions, you can add another important dimension to your stock picking and make far better decisions in the long run.

Step 1: Define Your Sectors

When you're trying to ensure that your portfolio will do well under a large variety of conditions, it's important to have enough diversification to offset the chances of the overall value of your holdings declining rapidly.

Imagine finding an amazing business and putting 100% of your money into that business. It's easy to visualize a scenario where luck runs against you, or where your assumptions about the underlying business are just plain wrong. It's even easy to imagine that you've missed something within an industry that causes nearly all of the stocks in the sector to decline, so even if you own several businesses within that industry, you might see a really big overall decline in your entire portfolio. In other words, it's important that you don't put all of your eggs in one basket, even if that basket is an entire industry.

While this is very intuitive and smacks of common sense, how, exactly, you should diversify is a much more challenging puzzle to solve. One very practical way to tackle this is to start by identifying different ways to divide stocks: by industry, by geography, or by type of stock. I recommend using the industry as a main foundation when initially structuring your portfolio, then coming up with an appropriate percentage for each sector.

A relatively simple example would be to make sure that you have 10% each in tech, industry, finance, real estate, energy, food/other commodities, utilities, healthcare, consumer discretionary, and consumer staples, totaling 100% of your portfolio allocation. It doesn't matter so much that you divide it up in the same way I'm suggesting, but it is important that you divide things up into sectors you're comfortable learning about and researching.

Maybe 25% in tech makes more sense for you, or perhaps you know a lot more about healthcare because you worked as an EMT for 10 years. Whatever the case, identifying your sectors and building your portfolio to match the desired amounts in each sector is the first key step in this investment strategy.

Step 2: Fill Your Sectors Up

Now that you have your sectors picked out, it's time to fill them up with stocks. In a perfect world, it would be fantastic to own only the very best stocks in each category, but it's important to remember the old Voltaire quote: "Perfect is the enemy of good."

It can be incredibly challenging to pick out the best stocks in any given industry, especially since we're not just talking about great businesses, but also the businesses that are most attractively priced at that particular time. This means understanding valuation at a very deep level, or at least understanding how to identify which stocks are among the best values today.

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Since it's so tough to guess which particular stock is the market leader, I suggest picking a number of businesses to own within a given sector. Depending on your personal appetite and bandwidth for research, you will need to determine that number, but I would suggest owning between five and ten businesses within each sector at a given time.

Because of the relatively high number of businesses you'll want to own within each sector, you need to take the time to understand the individual industry the stocks are located in so that you can know how these businesses make money and how to define whether one is successful.

Picking out five or ten businesses means you're much more likely to have individual fish jumps: individual stocks that do really well over shorter periods of time, even beyond their sector.

Step 3: Rebalance Periodically

Once your portfolio is divided up into sectors, and you've picked the best five to ten bargains at the moment, you need to remember that portfolio allocation is a process, not an event. You might start out with 10 stocks each in 10 sectors, with each sector representing 10% of the total, but in a few months, your allocation is likely to be very different, since the prices of your stocks are constantly changing.

This effect is doubly important since all 10 of your stocks in a sector might move up or down at the same time. Maybe this year, energy has risen 50%, while tech has declined 20%. It's important to revisit this concept regularly to check to see how far off the rails you are in terms of your target percentages.

In a static stock universe, if you sold a stock that was 10% of a particular sector, you'd just want to replace it with another stock in that sector (or add to an existing holding within that sector), but if the energy sector has doubled while tech has declined, you might consider buying another tech stock with this new money, bringing your total allocation closer to the percentages you originally intended to have.

This rough framework can be as rigid or loose as you need it to be, but having some kind of guideline—and checking it every three months or so—can be really helpful in guiding your individual stock-picking decisions. Sometimes, it's okay to deviate to some degree, and it might make sense to be overweight in a sector and to be comfortable with that depending on what's going on at the time.

The main point is that you can think about how to handle this and decide in your own way. If you have a principle in place, you are likely far better off than you would be if you had no principle at all, and while your guidelines might be dramatically different than my own, both of us can have the right guidelines for our own knowledge base, personal expertise, and comfort levels.

Diving Deeper

Once you've gotten good at this process, you may want to consider investigating across another dimension. If you've maintained your desired percentages for each industry, perhaps it would make sense for you to own a certain percentage of your portfolio in stocks that are fast growers vs. higher-dividend stocks, or maybe it makes sense for you to have 50% of your stocks in US-based companies, at least 20% in emerging markets, 10% in Europe, and so forth.

Think about different ways to test whether you have diversification across multiple dimensions, ultimately adding layer upon layer of insurance against a market crash or wholesale portfolio decline. Over time, you can sell your winners when you decide the time is right, and you'll know where to invest that extra capital—wherever it's needed in order to ensure that you have the right allocation of stocks in the right sectors.

Use this process consistently over time, and you can help to increase your chances for market-beating returns with relatively low risk compared to the overall market.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2021 Andrew Smith

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