For the record, I am not crafting a portfolio that is guaranteed to outperform the S&P 500, show gains in the midst of a bloody Wall Street scene, or bring alpha to any investor. What I want to do is show to some of the investors out there that they can build a portfolio that will be protected and relatively safe in the face of heavy volatility. Last fall, we saw a record amount of volatility, as each morning a new headline seemed to put the Dow up or down 200+ points-- and that being on the light end. However, by the time December 30th came around, (the last trading day of the year) markets essentially ended the year in the black.
How many investors saw their portfolios down 10%? 20%? 40%? Well, depending on which stocks one may have owned, in particular, financial stocks or high beta stocks, -40% probably wasn't out of the cards. My goal with this article is to construct a portfolio that can stare volatility in the face and shrug it off with ease. Many retail investors have been torched in the last ten years when it has come to investing in the stock market. Even though last year was not the tech bubble burst, nor the financial crisis of 2008, the sky high volatility caused many extra stress, sleepless nights, and most likely withdrawal of funds near the bottom.
Click to enlarge:
Above: 1 year chart of the VIX. Courtesy of StockCharts.com.
The VIX measures market volatility, and as one can see, was very low in July, but extremely high from August through November.
I put a lot of thought into which stocks would go into this portfolio, so I needed to come up with some criteria. One way to avoid volatility is to invest in bonds. But with yields so low, I wanted to keep this portfolio strictly in domestic equities. Obviously, in a paper account you can average down to infinity and make a killing during and after drawdowns. Unfortunately, that is not the case in the real world. The following are some of the criteria I put forth when considering how to beat this problem:
A market cap over $50 billion
A drawdown of less than 10% from July 1, 2011
A current beta of less than or equal to 1
A dividend yield of 2.5% or higher
I came up with twenty stocks. Of those twenty I narrowed it down to ten. I am going to construct a portfolio with a total value of $25,000. It will be comprised of seven different companies and have a cash position of 5-10%, which can be used for the purchase of protective puts, extra cash to purchase names on dips, start a new position, or just have around for emergency. Ideally, I would like a 10% cash position, and I twisted and manipulated the situation the best I could, but found that it was most beneficial to do it the manner described below.
Following is a table of the seven companies I chose. Please, remember that I am not building a portfolio for stunning future growth (though growth would be nice), or looking for my holdings to double in the next six months. The companies listed below did not suffer greatly from high volatility, pay out a steady dividend, or have a large market cap. These are companies that are for someone closer to retirement, or who is relatively conservative, who wishes to invest their money, observe slow, yet rising annual returns, and can go to bed at night knowing they won't see their portfolio down 5-10% in the morning.
Below: Desired portfolio after several purchases in Microsoft (MSFT), Coca-Cola (KO), Bristol-Myers Squibb (BMY), McDonald's (MCD), Kraft (KFT), Altria (MO), AT&T (T):
|Company||# Of Shares||Quarterly Dividend||Yield|
|Beta||Desired % Of Total Portfolio|
Below: The ranges for portfolio securities and draw down percentage.
|Company||7/1/11 - 12/30/11||High During Span||Low During Span||Largest % Draw Down from 7/1/11|
|MSFT||26.02 - 25.96||28.08||23.98||-7.85%|
|KO||68.09 - 69.97||71.23||63.96||-6.06%|
|BMY||29.15 - 35.24||35.29||26.38||-9.5%|
|KFT||35.47 - 37.36||37.74||32.8||-7.52%|
|MO||26.53 - 29.65||30.31||24.36||-8.17%|
|T||31.68 - 30.24||31.68||27.41||-13.47%|
Right off the bat, three things should be apparent to an avid investor:
Why does Coca-Cola have an asterisk by its number of shares?
How did AT&T make the list with a 13.5% drawdown?
I will answer all of these questions and more below.
There are several factors as to why JNJ, PG, and WMT did not make the "cut" in my Euro-Proof Portfolio. In many articles on Seeking Alpha one will see people building their long-term portfolios with those names, plus a few others like Coca-Cola and McDonald's, and there is absolutely nothing wrong with that. While my portfolio could be used for a long-term approach, it is simply meant more for battling volatility without the added stress. So yes, being slightly more original and trying to pick a few different stocks without surrendering performance was a factor. It should also be noted that WMT, PG, and JNJ were all down near, or over 10% from their July 1st levels.
However, the main reason I left those names out was simple. I wanted to get more diversity within my holdings, while still being about to utilize 100 share lots. By having six holding with 100 shares or more, I am able to write covered calls. Writing covered calls are effective in this situation for two reasons. First, if volatility is high, then that will increase the price of the covered calls I will be writing, which as we all know, will increase the premium I would collect per option contract sold. The second reason would be to create a second stream of income. While all these stocks pay a nice dividend four times a year, collecting additional monthly or bi-monthly income via writing covered calls is another great way to supplement one's income.
The reason behind Coke having an asterisk next to its 100 share position is quite simple. Earlier in 2012, Coke announced a 2-1 split of its stock, which will occur later this year, (pending shareholder approval in July). By accumulating 50 shares now, and doing so pre-split, one will be able to double their share count (though their cash position in the security would remain the same), and thus have another name in which they could write covered calls for.
And for all those folks wondering how AT&T made the cut, the choice was actually rather easy. The telecom giant has too fat a yield to leave out. With a yield over 5%, AT&T at least deserved a look. With a low beta, a solid yield, and a market cap close to $200B, the only thing keeping this one on the bubble was the company's -13.5% drawdown from July. I decided to make an exception here. Call me a hypocrite, but I decided to grant AT&T a mulligan after looking over its chart. Going into the second half of 2011, AT&T made its yearly high the same exact day, July 1st. So of course it had the most downside potential. While this isn't exactly an excuse for AT&T's performance, I used my best judgment overall.
As one can see from above, the average drawdown, at its darkest hour, was only -8.01%. Not great by any means, but between the bi-polar behavior Mr. Market was sporting and the record high volatility we all saw, I'll take -8%. And with a portfolio that is now yielding closer to 3.75%, one is really not looking at a poorly performing portfolio.
Please remember for what reasons I am building this portfolio. I don't want readers to think I am saying JNJ or PG are not good companies, and have no place with me. I just think having a portfolio with a few more securities will allow for better diversification, coupled with the ability to write covered calls. Obviously, solid dividend paying companies such as JNJ and PG are great core companies to build a portfolio around. I am curious to hear other opinions below and make the comment section an educated discussion amongst investors along with myself, rather than destructive criticism towards others.
Building A Euro-Proof Portfolio Part II, contains more about the individual positions I chose, at what levels I added them and when I plan to add more. For Part II>>