Head of Equity Strategy
Summary: Many retail investors are excited about single stocks and the stories attached to those stocks. Many retail investors often start by asking which stocks will do best. But that is the wrong place to start. One has to first think about the two major building blocks of a portfolio, also called beta and alpha, and how much to allocate to those two components. When that foundation is in place then the investor should start thinking about single stocks.
I often get the question from clients, friends, and family which stocks they should buy. I do not see myself as the new Warren Buffett although I do have many good ideas in terms of stock selection. However, asking about single stocks is the wrong way to start. Let me explain.
Ideally your wealth decision is an asset-liability problem. In other words, it is an optimization of your household balance sheet taking your assets, liabilities, income, age, spending etc. into consideration. It becomes quite a complex problem very quickly and something that is mostly available for wealthy individuals. I will instead focus on how to think about the investable part of the asset side; your investments in liquid financial instruments such as equities, fixed-income etc.
The alpha and beta soup
An investor's return can be broken into two components: alpha and beta. The latter is the market return and alpha is the residual. What is the market return? In its purest expression the market return is derived from the global market portfolio which is a portfolio with weights corresponding to the market value of all investable assets across equities, fixed income, real estate etc. For most retail investors implementing such as portfolio is not feasible. A simpler heuristic such as blending global equities and fixed-income using ETFs gives the investor essentially the global market portfolio with some degree of tracking error (a minor detail for most).
What is the typical alpha part? These are investments where you deviate significantly from the market portfolio. Let's say you invest 10% of your wealth in Vestas, then you have made an active bet, in other words, you are betting that Vestas will outperform the market portfolio. Alpha bets do not need to be restricted to equities, but for most retail investors that would be the natural choice.
How much risk should you take?
The next question is then how much of my investable assets should be invested in beta and alpha? This depends on many things such as your risk tolerance, age, income, other assets etc. There is no easy answer. My own split is 30% in an alpha sub-portfolio and 70% in the market portfolio.
What should the market portfolio consist of? For most retail investors it should be a balanced asset allocation portfolio using ETFs. There are plenty of opportunities in the marketplace for a low expense ratio and Saxo offers a great balanced asset allocation portfolio constructed by BlackRock, the world’s largest asset management firm. Personally, I have coded my own portfolio optimization framework which optimizes over 14 assets (equities, government bonds, credit, real estate, commodities etc.) with the objective of minimizing the CVaR (the conditional value-at-risk or tail risk) subject to minimum 6.5% annualized return and some other constraints; the framework also uses block bootstrapping to avoid bias towards the historical sample. This optimization done rolling over time creates the total return stream in the picture (y-axis is on log scale) which is part simulation and part live period; this strategy has an annualized Sharpe ratio of 0.91.
Thoughts on the alpha portfolio
My alpha portfolio consists of 30 stocks which all play on themes with an interesting long-term potential. I have invested in the following themes: carbon capture, semiconductors, sports fashion, fuel cells, gene editing, e-commerce in Asia, cloud computing, energy efficient pressurizer pumps, social media, copper mines, cure for hearing loss, shipping, plant-based plastic, electronic trading platforms, 3D printing, gaming, enterprise software applications, robotics, and fertility.
I view these alpha bets as risky and I demand the risk-reward profile to be high. As I view the world of equity investing, the point is to get high growth in your alpha portfolio. The objective should be to pick some of the winners in the future. Equities should be a bet on the future, innovation and productivity growth. The "value" part of investing comes naturally from the global market portfolio and anchors the portfolio at a lower risk point compared to a risky 100% equity portfolio. Many retail investors also like dividend companies, but the facts are that dividend aristocrats (those that lift dividends constantly over time) have not outperformed high yield credit for many decades. The global high yield total return index has delivered 8.9% annualized since August 2002, whereas the global dividend aristocrats total return index has delivered 7.8% annaulized.
For me that confirms that equity investing is not about dividends. I would rather invest in a company that constantly finds growth opportunities and reinvest its surplus earnings into those ventures. My final observation is that if you work in a certain industry then this knowledge can be quite useful for finding opportunities in your alpha portfolio.
Thinking about long-term expectations and risk
So what is my long-term expectation for such a portfolio? The market portfolio is designed to deliver 6.5% annualized return over the long-term so that is my expectation for beta. I expect the alpha portfolio to deliver 20% annualized return which sounds outrageously high, but it is based on my high risk-reward framework, more concentrated positions around convictions, high-growth themes, and opportunity to invest in smaller market capitalization companies because of my small capital base. One has to constantly evaluate the alpha performance and reduce the weight on the alpha portfolio if it does not live up to expectations. Multiplying my alpha and beta portfolio weights I get to a long-term return expectation of 10.6% annualized.
Estimating the percentage allocated to the alpha portfolio is difficult. But a simple and useful heuristic is to ask a question about maximum loss and how you would feel about such a loss. My beta portfolio has experienced a maximum drawdown of 22% and an aggressive alpha portfolio in single stocks could experience a drawdown of 60% in a market downturn such as we have seen during the dot-com bubble and the Great Financial Crisis. Multiplying my allocation weights gives me an expected maximum drawdown around 33.4% (the average maximum drawdown is of course lower, but one has to contemplate the maximum pain). That fits well with my own risk tolerance given my personal circumstances.
If that drawdown sounds like too much, an investor should then think about changing the market portfolio to a slightly less risk profile (moderately defensive or something else), but not too much as you are then deviating from the global market portfolio and thus making an active bet on bonds relative to equities. One could also just reduce the allocation weight to the alpha portfolio.
I hope it gave some inspiration about how to think about investing. So start with the big building blocks and then slowly add an alpha component, if you want the extra risk, and think about which single stocks fit into that box.
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