Investing PART 10: “Know when to hold ‘em, know when to fold ‘em.”

Or, as another song says, “Tick a, tick a, timing...timing is the thing it’s true…”

PART 9’s core holdings beg the question of when to buy which stock and when to add to positions. If you are buying all the stocks at once for the next 10 or 20 years, as the big bands say “hit it.” Don’t wait, just dive in. PART 9 listed 10 or so core holdings for a buy-and-hold strategy. One of the things that kept me from posting it earlier was all the gobbly guck about a lost decade for investors (that and the ability of people to take things out of context). People get hurt listening to advice. So, until now I've always avoided making mine public. The only thing that is more dangerous than advice is letting someone else manage your money.
You shouldn't become over-reliant on index funds generally even though some are useful for reasons that will be discussed in subsequent postings. It was a lost decade for S & P 500 index fund investors as shown in the table entitled “S & P CARG through 2010,” but not for people who held stock in companies that make money producing things people want.

The table entitled “CORE” presents the "lost decade" for that ten stock. They are listed by ticker symbol. (The CORE portfolio stocks are J&J (JNJ), Pepsi (PEP), Exxon (XOM), 3M (MMM), Bank of NY Mellon (BK), Boeing (BA), Verizon (VZ), Procter and Gamble (PG), PPG (PPG), and GE (GE)). Unlike the comparison S & P benchmark which is capitalization-weighted, it shows the performance of a portfolio based on equal starting weights (i.e., same dollar value in each stock). That’s totally consistent with the recommendation to focus on your dollars not the market.

The resulting performance of the CORE portfolio makes sense since people should be happy if a portion of their money grows on average 4.9% and spins off a bit of cash (another 3%) which also grows at about 5%. In fact, in some instances they should be happy with less as long as inflation doesn't take off.

However, by presenting the performance without dividend reinvestment, the table forces you to address where the returns should go. That said, for a core portfolio, don’t discount the benefit of just having the dividends reinvested. Reinvestment facilitates relative performance comparison since the portfolio weightings change over time in proportion to total relative performance. On a stock-by-stock basis you’re also practicing an approximation of dollar cost averaging (i.e., buying a fixed dollar amount periodically regardless of whether it is 2 expensive shares or 10 shares when the price is lower).

However, the objective is to build a diversified asset mix. These ten stocks are all large caps. In a previous posting (Angels, entrepreneurs and diversification: PART 3) there is a reference to difference in performance by company size: “The Motley Fools (http://www.fool.com) … discussed some research related to the role of small cap stock in a portfolio (see: ‘Scary Stocks Worth Buying Anyway’).” Even within publicly-traded stock portion of your portfolio, you want diversification. Thus, when this large cap portfolio is growing rapidly in dollar terms relative to your circumstance, you should consider shifting some of it out of the core portfolio.

Similarly, if you looked at “S & P CARG through 2010,” you probably figured out that buy-and-hold for the first 25 years of the 35 shown in the spreadsheet would probably built a pretty big portfolio. That would have been associated with a few years during the “internet bubble” where anyone who had held stocks for ten years should have been a little uncomfortable with the dollar value build up anyway. Add to that a coupon on 20 year TIPS that was over 3.5%, and it didn’t take a market timing expert to realize that it was time to diversify into bonds. The more relevant question was whether to do it from the core portfolio or from other assets.

Anyone who was in the market then and using the dollar-value approach knows the answer. Other asset classes had built up dollar values much faster. For example, the idea of selling some Corning (GLW) to buy United Technology (UTX) or TIPS would have come automatically, but that’s one of the less “screaming at you” examples.

Another approach that has an irrational appeal to me is to set a fixed target for appreciation in the core portfolio. The target can be a percentage increase (e.g., 6, 7, 8%) or sticking to the logic of relating investments to your circumstances, a portion of your income or living expenses (e.g., be that 10% or 200%). Either approach has the benefit of automatically increasing the dollar value of the target. (My personal preference is a portion of income. It automatically adjusts to changes in your living standard).

When the cap gain beats the target without reinvesting dividends, deploy the dividends elsewhere. Alternatively, when the portfolio is down or performing below the target based just on cap gains, reinvest the dividends in the core. Also, when it has fallen short of the target, consider adding new investment capital. For example, consider making that where your IRA contribution goes that year or sell something else.

Focusing on dollars also helps you make allocation decisions within the portfolio. I trim positions not based on percent of portfolio, but instead when any position gets large relative to my circumstances. If your objective is “alpha” (i.e., beating the market), there are better strategies for rotating between sectors, but they introduce there own set of risks.

The issue of timing is far more important for the part of your portfolio that is not core holdings. That will be addresses in future postings.

Most important of all, set a target. If you don’t have an objective, you won’t achieve it.