While the financial theory that gives us the portfolio allocation referenced above assumes that there is a natural trade-off between return and risk, real world research only finds that trade-off between asset classes. In other words, real world data supports the conclusion that stocks have higher risk and return than bonds, but not that risky stocks have higher returns than safer stocks.
In fact, historical data shows that safer stocks have actually had higher long-term returns than risky stocks. This is called the low-risk anomaly (a.k.a. low-beta anomaly or low-volatility anomaly.) A consequence of the low-risk anomaly is that a portfolio of low-risk, high yield stocks is likely to have higher returns and yield than typical portfolios of stocks or bonds, or combinations of the two.
Investors who are aware of the anomaly and are willing to flout conventional wisdom can have their cake and eat it, too. Especially in the current low interest rate environment, a portfolio of low-risk, high income stocks is likely to have both higher current income and higher returns so long as the anomaly holds.
The benefit of owning a large number of stocks is diversification: If economic or political events harm a single company or industry, good diversification will keep the rest of the portfolio safe. For the small stock investor, diversification comes with a trade-off of higher transaction costs, which is one of the main arguments for using mutual funds and ETFs. However, large mutual funds also have trading costs, especially in the form of the tendency for large trades to move the market price. As Micheal Lewis relates in his recent book, Flash Boys, it is these large transactions that high frequency traders are able to exploit, at the expense of the mutual fund investor. The trades of an individual are far too small for high frequency traders to both with.
To keep trading costs low, a good rule of thumb is to keep brokerage commissions to no less than 0.5 percent or 1/200th of any transaction, and trade as little as possible. That means that if you pay $8 per transaction, each trade should be for at least $1,600 (=$8 x 200.) Thus, an investor with a $20,000 account could have as many as 12 positions without violating this rule. If a portfolio is too small to have 10 positions using this rule, the diversification of a mutual fund is probably a better choice until the account grows. For larger accounts, transaction size should increase as well to further reducing investment costs. 20 positions should be plenty for the purpose of diversification if care is taken to select stocks in a wide range of industries that behave differently in various economic conditions.
To select a 10 stock portfolio from a list like the one shown with this article, start by selecting the stock from each industry with the best combination of low beta (to take advantage of the low beta anomaly) and high yield (to compensate for not including fixed income.) In this case, we have 8 industry groups for eight stocks: INTC, MRK, VE, PG, JCI, TD, JLL, and ITC. To complete the portfolio, take the next two highest yielding, low beta stocks, so long as they are not in the same industry: RHHBY and PEP.
An investor who buys equal dollar amounts of each of these 10 stocks will have a moderately diversified, low cost, low beta, relatively high yield (2.8 percent), fossil-free portfolio.
Closing The Circle
Jan Schalkwijk, a green investment advisor at JPS Global Investments, says that when using this strategy, it is very important not just to buy the stocks and forget about them, but also "close the circle." To follow this strategy effectively, an investor should update the portfolio periodically.
To see why updating the portfolio over time is important, consider a 5-stock "tracking portfolio," which was designed to mimic the performance of the alternative energy mutual funds using a similar procedure in 2009. Six months later, the tracking portfolio was out performing the funds it had been drawn from. But after 5 years, one of the five companies (Suntech Power) in the portfolio had gone bankrupt. While the portfolio also contained a stock that had more than doubled, the portfolio as a whole was up only 1.5 percent over five years. The three mutual funds it was drawn from had an average return of 61 percent over the same period. Most likely the mutual funds avoided similar losses in solar stocks before the worst of the sector's troubles in 2011 and 2012.
A good procedure for updating the portfolio would be to repeat the exercise used to construct it whenever you add or withdraw money, or every two years if no additions or withdrawals take place. If a stock in the portfolio no longer appears or has been greatly reduced in the mutual fund holdings you consider, it should probably be sold. However, in order to keep trading at a minimum, the stock should not be sold if it just falls out of the top ten holdings but is still a significant portion of one or more funds' portfolios. Half of any position that has doubled in value since it was purchased should also be sold in order to keep that stock from becoming too large a part of the overall portfolio and reducing the overall diversification.
The proceeds of sales and any new additions to the portfolio can be invested in new stocks selected using the same procedure outlined above: spread the portfolio as widely as possible across different industries while choosing stocks with high yield and low beta within each industry.
DISCLOSURE: Long VE.
DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results. This article contains the current opinions of the author and such opinions are subject to change without notice. This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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