A Focus on Portfolio Allocation

By Al Levit (TMF Early)

GLENDALE, CA (May 5, 1999) -- Monday, Tom started our week-long discussion about adding money to a Rule Maker portfolio. Yesterday, Phil added his thoughts. Tonight, I'm going to add my perspective in the context of overall portfolio allocation.

To the Wise, the term "portfolio allocation" typically refers to a portfolio's varying composition of the three major investment assets: stocks, bonds, and cash. But, this is not the portfolio allocation that I'm speaking of here. In Fooldom, we strongly believe that stocks are far and away the most rewarding long-term investment. Since 1802, an investment in stocks has, on average, doubled in purchasing power every ten years. In contrast, an investment in bonds has, on average, taken twice as long to double in purchasing power. That's why Fools, with at least a five-year time horizon, add money to stocks.

But which types of stocks? And, what percentage of my portfolio's total value should go into any one holding?

Tonight, I'll attempt to shed light on these questions as I focus on how additional money is allocated in an already established portfolio.

A well-balanced portfolio will normally have at least two of the following three components:

1) A core of Foolish Four stocks that make up 20-30% of the entire portfolio,

2) Rule Makers that make up the majority of the rest (normally between 50% and 80% of the total);

3) And for those who care to take extra risk, up to 20% of the portfolio in "additional" companies. These would normally be chosen from:

a) Tweeners, who will hopefully grow into Rule Makers (such as Yahoo! in the Rule Maker portfolio)

b) Rule Breakers who will hopefully grow into Rule Makers, or

c) Merchant Kings.

My first job is always to make sure that allocation among the three major categories looks okay. For me, this allocation is always based on each stock's current market value. For example, if my Foolish Four dips below 20% of the total portfolio value, then I make sure to add to the Foolish Four the next time I buy stock.

As a sidenote, I should mention that I do all of my Foolish Four investing in a tax-deferred account. One advantage of having changed jobs a few times is that I've rolled over some large distributions from 401(k)s into self-directed IRAs. Outside a tax-deferred account, investing in the Foolish Four is considerably less appealing because of the annual capital gains taxes. (For more on the sharp bite of taxes on a portfolio's returns, see this column from last month.)

In any event, I'll assume that the Foolish Four portion is in good shape. I'll also assume that I'm not interested in adding anything from the third, more risky, category of Tweeners, Breakers, or Merchant Kings. Therefore, I'm looking to add more shares of a Rule Maker to my portfolio. The next question is whether I want to add more shares of an existing holding, or to introduce something new.

My natural inclination is always to add more shares of a company I already own. I do this for a variety of reasons. For one, my portfolio already has the diversification of ten Rule Makers spread across a number of industries. Second, my existing -- and ever expanding -- base of knowledge about these companies alleviates the need to do any further research if all I want to do is buy more shares of any of my current Rule Makers.

Before buying more shares of these companies, however, I like to check a few things. First of all, I don't want too much of the entire portfolio riding on one stock, nor do I want excessive exposure to a single industry. How much is too much? That varies by person, but I wouldn't add shares to any stock that was over 10% of my portfolio, nor would I add to any industry that was over 35% of the total. This rule does not mean, however, that I would sell a stock because it grew to be more than 10% of my total portfolio. No, I would let a winner run well beyond the 10% level before selling off a portion. (I personally haven't faced this "dilemma," so I don't know what exact level would be too great a portion for one of my holdings.)

Once I've narrowed down the list of stocks to buy, I behave in a manner you might not expect for a Rule-Making investor. As you know, we believe that business quality is much more important than valuation -- perhaps 1,000 times more important. However, among the Rule Makers in my portfolio, usually two to five are candidates for additional investment. At this point in the process, I look at each company's valuation to see which one offers the best buy. Since all of my candidates are Rule Makers with outstanding business models, I feel no shame if I can also get the shares at a decent price.

I buy shares infrequently, and I find that different Rule Makers come up as "good buys" at different times. By looking at valuation, I believe that I get outstanding companies at slightly better overall prices. In addition, I should point out that I only use this valuation method when buying additional shares of an existing holding. When I'm adding a Rule Maker for the first time, I don't worry about the price at all.

As Phil pointed out yesterday, we both tend to buy the same stocks over and over throughout a period of years. This process, in itself, is a form a dollar-cost-averaging and is almost standard practice in Rule Maker investing.

That's enough from me on adding new money. Tomorrow, you'll hear from Matt.

Until then Fool on,


05/05/99 Close

Stock Change    Bid
AXP   +2 1/4    129.38
CHV   -  1/4    100.06
CSCO  +2 11/32  110.97
EK    +  7/16    77.69
GM    -2 1/16    86.94
GPS   -  1/2     69.38
INTC  +2 5/16    64.00
KO    +1 13/16   70.50
MSFT  +1 1/16    79.13
PFE   +4 1/16   118.31
SGP   +  7/8     50.56
TROW  -  5/8     37.75
XON   -1 11/16   84.81
YHOO  +2 1/16   161.31

                  Day     Month  Year    History
        R-MAKER  +1.05%   0.39%  12.52%  42.38%
        S&P:     +1.15%   0.91%   9.92%  35.97%
        NASDAQ:  +1.98%  -0.33%  15.58%  53.33%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     79.13   102.19%
    5/1/98   55 Gap Inc.      34.37     69.38   101.85%
   6/23/98   34 Cisco Syst    58.41    110.97    89.98%
   2/13/98   44 Intel         42.34     64.00    51.17%
    2/3/98   22 Pfizer        82.30    118.31    43.76%
   2/17/99   16 Yahoo Inc.   126.31    161.31    27.71%
   5/26/98   18 AmExpress    104.07    129.38    24.32%
    2/6/98   56 T. Rowe Pr    33.67     37.75    12.11%
   8/21/98   44 Schering-P    47.99     50.56     5.35%
   2/27/98   27 Coca-Cola     69.11     70.50     2.02%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     84.81    31.83%
   3/12/98   20 Eastman Ko    63.15     77.69    23.03%
   3/12/98   17 General Mo    72.41     86.94    20.07%
   3/12/98   15 Chevron       83.34    100.06    20.06%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    5/1/98   55 Gap Inc.    1890.33   3815.63  $1925.30
    2/3/98   48 Microsoft   1878.45   3798.00  $1919.55
   6/23/98   34 Cisco Syst  1985.95   3772.94  $1786.99
   2/13/98   44 Intel       1862.83   2816.00   $953.17
    2/3/98   22 Pfizer      1810.58   2602.88   $792.30
   2/17/99   16 Yahoo Inc.  2020.95   2581.00   $560.05
   5/26/98   18 AmExpress   1873.20   2328.75   $455.55
    2/6/98   56 T. Rowe Pr  1885.70   2114.00   $228.30
   8/21/98   44 Schering-P   2111.7   2224.75   $113.05
   2/27/98   27 Coca-Cola   1865.89   1903.50    $37.61

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1696.25   $409.55
   3/12/98   20 Eastman Ko  1262.95   1553.75   $290.80
   3/12/98   15 Chevron     1250.14   1500.94   $250.80
   3/12/98   17 General Mo  1230.89   1477.94   $247.05

                              CASH     $70.09
                             TOTAL  $34256.40

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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