Security selection to fill asset classes and market factors.
What weight to assign to different asset classes and factors?
Position Sizing: Controlling portfolio risk.
Portfolio Management: Using the Kipling workbook.
Portfolio construction goes well beyond selecting a few individual stocks. This article contains ideas that will be "old hat" for some readers, but I promise to include material that will be fresh for many.
Diversification: We begin with the concept of global diversification. While it is somewhat complicated to carry out global diversification when dealing in individual stocks, it is quite easy to fulfill this requirement using index mutual funds or Exchange Traded Funds (ETFs). Since I personally use ETFs, I'll use them as examples in this article. To begin, here are several broad areas to consider when building a diversified portfolio. Below are four critical asset classes to consider. Specific ETFs will be recommended later.
- U.S. Equities
- Developed International Equities
- Emerging Market Equities
- U.S. Bonds
In addition to the "Big Four" asset classes, here are additional asset classes to consider as one builds out a diversified portfolio. Investors may not wish to include all these asset classes.
- International Bonds
- U.S. Real Estate
- International Real Estate
- U.S. Treasuries
In addition to including specific-asset classes in a portfolio, I suggest including or emphasizing factors that have shown themselves to be particular market anomalies. Here are those I include in a portfolio.
- Size - Use small- and mid-cap ETFs.
- Value - Use ETFs that seek out value stocks.
- Momentum - Include at least one momentum oriented ETF. An example is listed below.
It is possible to fulfill the size and value requirement in one ETF.
With diversification well in hand, we drill down to security selection.
Security Selection: Let's begin with the "Big Four" asset classes. Investors will find there are many options or mirror ETFs one might use to populate these asset classes. Here are examples.
- U.S. Equities (SCHB)
- Developed International Equities (NYSEARCA:SPDW)
- Emerging Market Equities (NYSEARCA:SPEM)
- U.S. Bonds (SCHZ)
Factor ETFs: If readers are not familiar with "factor investing," I highly recommend reading "Your Complete Guide To Factor-Based Investing" by Andrew L. Berking and Larry E. Swedroe. Here are recommended ETFs to supplement basic asset classes.
- Size: Small-cap stocks are a market anomaly (SLYV and SCHC). SLYV incorporates both small size and value.
- Value: Stocks or securities with a high book/price ratio are highly valued. No pun intended (MDYV and SLYV).
- Momentum: While the Kipling workbook (more on this below) uses the concept of momentum, I also recommend holding at least one momentum ETF in the portfolio (MTUM).
Weight of ETFs: It is easier to show the assigned weight in a table than to describe in writing. Below is a sample portfolio housed at Schwab brokerage. This portfolio covers the "Big Four" asset classes plus U.S. REITs, treasuries, gold, etc. In the column, Strategic or Max AA is the maximum percentages each ETF is permitted. These percentages can be changed in the Kipling spreadsheet. Percentages will vary from investor to investor depending on what risk control is required.
The percentages sum to greater than 100%. The logic is that not all securities are part of the portfolio at any one time. This will be explained later in the article. The Kipling is designed to keep the investor away from weak asset classes and invested in strong asset classes.
SH is a short-the-market ETF that is rarely used. I include it for times when the market is in a swoon. If SH is held in the portfolio, and this is rare, the portfolio needs to be reviewed every day. SH is a short-term holding if it is ever used.
Position Sizing: Position sizing is nothing more than taking care not to put all your eggs in one basket. This is related to the general topic of diversification. Constructing a portfolio that has a Stock/Bond ratio of 60% stocks and 40% bonds is quite common. However, this is not a particularly conservative portfolio as shown in this article.
Here is a definition of Position Sizing from Investopedia.
Position sizing refers to the size of a position within a particular portfolio, or the dollar amount that an investor is going to trade. Investors use position sizing to help determine how many units of security they can purchase, which helps them to control risk and maximize returns."
This calculation is automatic for investors using the Kipling spreadsheet. Users of the Kipling can control the size of a position by setting the Max Percent for Asset Allocation and the spreadsheet also sets maximum shares for a particular security. Risk control is paramount.
Why is Position Sizing so important? While much attention is given to portfolio return, less attention is paid to portfolio risk. Both are important and when the market is high, as is currently the case, control of portfolio risk takes on an added importance. Control of risk is also important for investors who are older and have fewer opportunities (years) to recover from major market draw-downs.
Portfolio Management: Assuming you have determined what asset classes and market factors to include in the portfolio and you know which securities you are going to include in the investment quiver, how do you go about managing the portfolio? This area of investing is given less attention than any other. Many folks just turn everything over to a professional manager. This move can turn out to be quite expensive.
To handle this part of investing, I turn to the frequently mentioned Kipling workbook. To gain a broad overview of the Kipling, check out this YouTube video. This is an older version of the spreadsheet, but the basic worksheets remain the same.
In addition to the Portfolio worksheet shown above and the Main Menu of the workbook, there are several critical worksheets. The first is what is called the Tranche worksheet and it is shown below.
Within the workbook are three models or systems for portfolio management. In this example, I have it set to the Linear Regression (LRPC) model. With the maximum number of assets (ETFs) set to five (5), the current Buy recommendations are to purchase shares of SCHH, SCHZ, SPTL, SGOL, and PCY. Note that no U.S., Developed, or Emerging Market Equities are recommended. None! All the recommendations are REITs, Bonds, Treasuries, or Gold. I consider these to be conservative positions.
Now, we know what ETFs to purchase. But how many shares do we buy, assuming this is a $100,000 portfolio? This is where Position Sizing comes into play.
Position Sizing Recommendations: The following screenshot or table is the worksheet where risk is controlled. The red arrow directs your attention to a percentage that ultimately determines the Maximum Portfolio Risk. In this case, it is 8%. That may be too high for many investors. If it is, lower the 1.6% to 1.5% or even lower. I try to keep the Maximum Portfolio Risk somewhere in the 5% to 6% range.
What this Position Sizing worksheet does is to take the available cash or $100,000 in this example, and recommend the number of shares to purchase for each of the Buy recommendations. This resulting recommendation is also impacted by the maximum percentage set back in the Portfolio worksheet. If those percentages are set to 100% in each case, we permit the Position Sizing worksheet below to have maximum flexibility.
Manual Risk Adjustment Worksheet: This final worksheet is where the money manager or investor takes complete control of the portfolio. Recommendations from the above Position Sizing worksheet are transferred to the worksheet shown below. That data is found in column nine from the right-hand edge. For example, 430 shares of SCHH are recommended for purchase.
In column 8 from the right, the investor selects the number of shares to purchase for each recommendation. I round these recommendations as I try to match what I am going to do based on recommendations from the Position Sizing worksheet. For example, I plan to purchase 690 shares of PCY instead of the recommended 689 shares. There is a cell identified as Total New Cash where you keep track of how much cash is still available, assuming the security prices have not changed. If that cell turns negative, the investor will need to reduce the number of shares to purchase for a particular security.
Hints: Here are a few hints when working with the Kipling spreadsheet.
- Limit the number of asset classes and factors to a total of somewhere between 10 and 15 in number.
- Set the Maximum Number of Assets to one-half the maximum number of assets. Aggressive investors will concentrate the portfolio by using only two or three ETFs. Conservative investors will increase the number for greater diversification.
- As mentioned above, there are three investing models available.
- HA is the least tested model. I am testing it using a portfolio known as the Carson HA. More information is available if readers are interested.
- BHS is a popular model and one that is faster to react to market changes. It also results in more transactions. This model turned in the top returns from extensive back-testing. I'm currently testing the BHS model with a portfolio that goes by the name, Carson BHS.
- LRPC model is slower to react to market changes. I'm currently testing it with a portfolio called the Carson LRPC. Over the last few months, this is the best performing portfolio by a wide margin.
Readers now have a working model from portfolio design to portfolio management. Having worked with this momentum oriented model for a few years, I've come to the conclusion that it tilts toward risk control. It definitely helps the investor protect capital.
Disclosure: I am/we are long SCHH, SPTL, SGOL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.