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.