The key assumption here is that the superiority of the security selection will dominate if not override the asset allocation choice. An investor using this strategy probably isn’t thinking in those terms, but that’s the dynamic in play, recognized or not. As a side note, most efforts on this front will probably fail to add value over a relevant index—the S&P 500, for example, if the 10 stocks are drawn from a pool of US large-cap equities. But that’s not the point, at least not here. Rather, it’s essential to understand the risk structure that defines and drives your portfolio. Why? Because flying blind and hoping for the best is never a foundation for success with financial decisions.
When you think clearly about the true nature of the portfolio-design process, you’ll make better choices. The first order of business is appreciating how the game is played, recognizing the rules as written by the markets, and using that clear grasp of reality for figuring out how to proceed in a way that stacks the odds in your favor to the fullest extent possible. Ultimately that leads us to see every portfolio as a preference about asset allocation. There’s a spectrum of possibilities beyond this initial factor, of course, including the question of how to manage an asset mix through time (rebalancing)—a topic that warrants quite a lot of discussion and research. But not here. Rather, my only point now is that it’s vital to see the asset allocation framework that’s inherent and unavoidable in every portfolio.
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Burst Of Clarity
This is crucial because once we can objectively see the tactical and strategic choices before us, we can move ahead in a productive way that’s likely to satisfy our specific investment goals. This is a subtle but powerful point because if you can recognize the true nature of the portfolio options available, the resulting burst of clarity will help us make intelligent choices. The truth shall set you free. This is less about hitting home runs vs. avoiding high-risk bets with low odds for success.
Thinking in these terms will keep you focused on the risks you’re taking. That alone is worth a lot–much more than most folks know. Let’s say that you’re convinced that you can identify individual securities with above-average expected returns. Perhaps that inspires a larger-than-average bet on this skill. In the extreme, this view leads you to shun diversification across the major asset classes. That’s a risky bet, but as long as you’re making an informed choice, and understand what that choice entails, you’re at least in control of the risks you’re willing and able to assume rather than the other way around.
Lots Of Options
Overall, it’s (still) all about risks, and deciding how they compare and which ones you’re intent on emphasizing and avoiding for portfolio design. There’s a sea of possibilities. Global minimum variance, risk parity, equal weighting, fundamental weighting, cap-weighting, etc. Or your own home-grown strategy–sidestepping broad asset class diversification and betting the farm on security selection within a single asset pool, for instance.
Pick your poison… carefully, intelligently, and with eyes wide open. This isn’t a sure-fire solution to big gains, but it’s a powerful plan to keep you out of trouble. Why’s that important? Because there’s overwhelming evidence that you can’t earn a decent return in the long run unless you have a solid plan for steering clear of big mistakes in the short term. Obvious, perhaps, but too often ignored in practice.
