The Pyramid For Portfolio Profits

It’s been a wild time in the markets, and that can make for dangerous times for investors. The stocks with the biggest gains in 1999 were those with no earnings and big losses. Meanwhile, uncertainty about inflation, interest rates, and the economy make the stock markets very volatile. Many investors are thinking of overhauling their investment plans.

That makes this a good time to review our overall portfolio strategy. It has served us well for years and will continue to do so. Our strategy is unique in that it lets us invest for the long-term, using patience and compounding to build our wealth. But it also enables us to adapt to changing economies and markets, staying on top of the latest trends.

You’ve probably heard of the traditional investment pyramid for constructing a portfolio. At the broad bottom of the pyramid are safe assets: certificates of deposit, money market funds, and short-term bonds. These, according to the theory, should be the biggest portion of your portfolio. More volatile and riskier assets are added as you go up the pyramid. The idea is that the riskiest assets are at the narrowest portion of the pyramid and therefore should be the smallest portion of your portfolio.

But we have a different pyramid that works much better.

At the bottom of our pyramid is the Core Portfolio. This is a long-term, balanced, diversified portfolio. You determine your long-term goals and risk tolerance, then set up a long-term portfolio that will meet your return goals while taking risks you can tolerate.

For example, if you won’t need distributions from the portfolio for 10 years or more and can tolerate fluctuations in value, you can put most of the Core Portfolio in different types of stocks. If you are more conservative or have a shorter-time horizon, put less in stocks and more in lower-returning but more stable assets, or at least in the less volatile stocks..

Changes in the Core Portfolio are few and far between. When market fluctuations knock the allocation of the Core Portfolio out of balance, you put it back into balance. As stocks appreciate, for example, and increase the percentage of the portfolio that is in stocks, sell some stocks and put the proceeds into bonds or other assets. You normally need to do this only once or twice a year.
The only other changes to make are when a mutual fund needs to be replaced because of a manager change or other long-term development.

Other than those two events, the only times to consider altering the Core Portfolio are when you believe there is a change in the long-term outlook for an asset or when your goals or risk tolerance have changed.

The Core Portfolio provides several advantages. It ensures that we are always in the markets. We aren’t tempted to pull completely out of any market that we want to be in for the long term. Studies show that most gains in bull markets are compacted into remarkably few trading days. Those days occur when least expected. If you are out of the market on those days, you miss most of the bull market gains. (Though that hasn’t been true for the last year or so.) The long-term growth of the markets and compounding work to steadily, relentlessly increase the value of our Core Portfolio.

The Core Portfolio also keeps our costs low, because we don’t make many changes. That also keeps taxes low, since we make few purchases and sales. The sales we do make can be made with long-term holdings, qualifying for lower tax rates than the tax on assets held for less than one year.

The next part of the pyramid is our Managed Portfolio. In this portfolio we try to capture the current investment or economic cycle by investing for one to three years. We are more active here than in the Core Portfolio with the intention of capturing higher returns and also reducing risk. We look to buy assets that have been beaten up and are selling at discounts or that will benefit from the latest stage of the markets.

We add a Managed Portfolio because the markets change over time. In the Core Portfolio, I like to own primarily value stock funds. Studies show that over time value funds get higher returns with lower risk than growth funds. They are a good way to steadily increase wealth over the long-term. But growth stocks and small stocks do have their days. The last few years have been great ones for growth stocks and dismal ones for value stocks. We’ve been able to benefit from that through the Managed Portfolio. In that portfolio we captured the growth trends that have dominated the U.S. stock market. The Managed Portfolio starts with the Core allocation, then makes adjustments according to market trends.

We’ve also been able to use the Managed Portfolio to capture big capital gains from assets that aren’t in the Core Portfolio or by increasing some assets to a level we wouldn’t want for the long-term. In the past, we bought zero coupon bonds when interest rates were unusually high and sold them after rates fell. I don’t recommend zero coupon bonds for most long-term portfolios. But they can be great investments for a one- to three-year period. We also have periodically increased our emerging market and other allocations by adding them to the Managed Portfolio.

Finally, at the top of our pyramid is the Aggressive Portfolio. This is not for everyone. An aggressive portfolio takes more risk and invests in more volatile assets with the goal of earning higher returns over the long term. Most aggressive investing strategies require you to regularly monitor your investments, perhaps every day. We don’t do nearly as much work with the Core and Managed Portfolios.

Our Aggressive Portfolio, using my Invest With The Winners system, has done quite well over the years. We use the mutual fund rankings included with each issue to determine which funds to buy, and we use sell signals to preserve our gains and avoid large losses. You were sent these rules with your new subscriber materials. I’ll be updating you on the Aggressive Portfolio and its results in next month’s issue.

The amount of your total portfolio that should be in each portion of the pyramid depends on you. I know some readers don’t want to do much work on their investments. They are content to have all or most of their investments in a Core Portfolio. They’ll let time and the markets compound their portfolios and not worry about shorter-term results or events.

Other investors are willing to put more time into their investments or need higher returns to meet their goals. They put a high portion of their total investments into the Managed and Aggressive Portfolios.

Some investors combine my recommended portfolios. They use the Core Income Portfolio for most of their assets to get income and security. The rest of their money goes into a Managed Sector or an Aggressive Portfolio. They are willing to take more risk with that portion of their money. because the Core Income Portfolio ensures their current standard of living. They can take more risk with their other assets to pay for extras or build a legacy for their children.

Here’s another variation I learned of recently. Some people put a large portion of their net worth in ultra-safe investments such as money market funds. The rest they invest quite aggressively. The portion in the money market funds is enough to maintain their standard of living, so they won’t be hurt even if they lose everything in the rest of the portfolio. That lets them invest for maximum gain with maximum risk in the markets.

In my recommended allocations in each issue I give a blended portfolio which assumes an investor splits a portfolio evenly between the Core and Managed Portfolios and has nothing in the Aggressive Portfolio.

A guideline you might want to consider is the practice of major pension funds. Many funds will put 5% to 20% of their total portfolios into an aggressive approach. This often is given to an outside money manager who uses futures and timing signals to switch between different market sectors. Or it might go into high risk investing, such as venture capital. Another 20% to 40% of the portfolio will be handled like our Managed Portfolio. The fund will increase or decrease its allocation to different investment categories of its core holdings based on market conditions. The rest of the portfolio will be the core holdings that won’t change. These are just broad averages, and each fund does things differently.

You need to select the combination that best fits your investment style and goals. The important lesson is that instead of picking individual investments, you should build an investment portfolio. Know where each investment you pick fits in the portfolio and how it helps achieve your goals.