[This popular column ran in a different form earlier this year.]
How much risk do you want? Quantifying and accepting risk is something anyone can miscalculate -- and many did during the last great bull market runup in 1999-2000. That possibility is here again as the market's 12-month bull run may encourage people to again discount risk and take on too much.
Even the great investor and finance teacher Benjamin Graham went wrong on risk. The Crash of 1929 almost completely wiped him out. He had to sell his abode and move his family -- only a relative's help kept his business from bankruptcy. Then he spent the rest of his life refining, practicing, and teaching a value investing strategy, most famously published in Security Analysis (classic 1940 edition, with changes from the 1934 edition, available now). Some of his Columbia students -- Warren Buffett received an A+ in his class -- profited from his learning.
I hope today to stimulate your thoughts about risk in your own investing life. Here's how I manage my own portfolio to accept varying risks and potential returns and still sleep at night. Your mileage should vary.
Portfolio allocation
By portfolio allocation, I don't mean asset allocation -- a specific investment strategy where you choose assets such as stocks, bonds, and real estate that don't behave in the same way to achieve more predictable returns with less risk. Rather, I mean allocation within an all-stock portfolio among stocks that represent varying risks, a way to try to outperform the broad-market averages, while at the same time keeping risk vs. return at your comfort level.
This is the allocation I currently use:
- 30%-40% dividend-paying stocks of businesses offering growth; large-capitalization companies that dominate their industries; S&P 500 or other low-expense, broad-market stock index fund; cash waiting to be invested. Examples: Microsoft (NASDAQ:MSFT),Nokia (NYSE:NOK), UST (NYSE:UST).
(For ideas on the dividend side, our newest stock newsletter, Mathew Emmert's Income Investor. offers terrific selections each month.) - 20%-30% highest risk, highest potential reward: Informed speculations including Rule Breakers, shorts, options, special situations. Examples: XM Satellite Radio (NASDAQ:XMSR), a Rule Breaker; Sun Microsystems (NASDAQ:SUNW) call options; ARM Holdings (NASDAQ:ARMHY), MRV Communications (Nasdaq; MRVC), Praecis Pharmaceuticals (NASDAQ:PRCS).
(For more on Praecis, check out Speculating in Biotech.) - 40%-50% value investments, usually small-cap stocks with little or no following. Buy at a discount to low-range estimate of intrinsic value and consider selling at a high-end estimate. Examples: Atlantic Tele-Network (AMEX:ANK), Quality Systems (NASDAQ:QSII), Sportsman's Guide (NASDAQ:SGDE), CNS (NASDAQ:CNXS), and Point.360 (NASDAQ:PTSX).
(Value Stocks in Your Portfolio provides more, and Tom Gardner's Hidden Gems newsletter relies heavily on valuation and free cash flow to identify market-beating off-Wall Street companies.)
Regular readers will see that I've lowered the percentage for the first category and upped that for the value category. That's because of greater comfort with the detailed financial statement analysis, which is especially important for smaller, unknown companies. This allows confidence in buying, say, a decent but not great business if it is selling for a very attractive valuation. I outline my two-step valuation approach in A Buy and Two Sells.
You can always find this three-part allocation and the stocks I own listed in my profile. (Every Motley Fool employee publicly discloses all stock holdings directly or beneficially owned, and we Fool analysts are investors writing for investors, not those who sit on the sidelines and pout.) There are currently 19, because I usually start buying a stock with 5% of my current portfolio value, moving to 10% as a full position. I'd prefer to have a smaller, more focused portfolio of, say, six to 12 stocks, because even though this is my job, it takes a lot of time and energy to keep up with the quarterly reports and conference calls for 19 companies. This is just one reason Jeff Fischer gives in his excellent 5 Investing Don'ts for a focused port. I'm planning for fewer holdings as the winners and losers sort themselves out over the years.
Some of the 10% positions will appreciate and take on a larger share of the portfolio, but I won't buy and sell simply to maintain arbitrary percentages for the categories. As long as a business performs well and its valuation still offers potential returns reasonable for the risk, I'll let winning stocks take on ever-larger shares.
Your allocation will vary
Can you right now write or type out your stock holdings and classify them according to risk? Before you start, follow the old saw: If worrying about the market is keeping you up at night or distracting you from your work and relationships, you hold too many risky stocks or have not adopted a strategy that allows you to keep emotion out of investing. Each is a sign that you may need to reevaluate your portfolio.
All stock investing presents risk versus, for example, a money market account, certificate of deposit, or stuffing the cash in the mattress (which present another risk -- inflation). The most risk-averse investors will be best off with 100% in a low-expense index mutual fund that mimics a broad-market average, like the S&P 500 or Wilshire 5000. With confidence, you can move into individual stocks through the "index plus a few" strategy. If you are knowledgeable about certain industries, you might choose to allocate a greater percentage there.
And always remember that you can have a long, happy investing life without owning any stock in my third, high-risk category.
On the way home
I'll be back in the U.S. for next week's column and look forward to seeing you then. If you'd like an email alert of my weekly Tuesday commentary, please send me a note at [email protected] with "mailing list" in the subject line.
Have a most Foolish week and thanks for reading!
Motley Fool Senior Analyst Tom Jacobs is typing this from a 50-seat Internet cafe in Riga, Latvia, sitting next to an Estonian law student listening to MTV.com and playing Counter Strike, the same computer game favored by Motley Fool techies after work on Fridays. He thinks Tom's jester cap is funny. Tom owns the stocks mentioned here plus more listed in his profile in accordance with The Motley Fool's world-class disclosure policy.
