Addition by Subtraction

I rarely feel highly confident that a particular sector of the economy is going to outperform the rest. More often, I have a view that a particular sector will underperform (call me a pessimist if you like). Therefore, my method of portfolio construction begins with selecting a large number of stocks that will both limit exposure to the travails of any individual company (i.e. idiosyncratic risk) while providing exposure to the various sectors of the global economy, with sector weightings in line with those of the global stock market. Then I simply cut out or reduce the weights of any particular sectors I feel will underperform. For example, in looking at the model portfolio holdings listed in the posts below, you may have noticed an absence of (think: Al Gore voice) banks and 'big oil' companies.

I see banks as leveraged plays on bond holdings and I don't think highly of the risk/return profile of bonds (100% potential loss with minimal potential gains in the context of an uncertain world: see Black Swan). As for Big Oil, my view isn't predicated on the price of oil per se (in fact I think the price of oil could easily rise very high, very fast), but is based on the idea that oil companies' costs (of extracting the oil) will rise even faster than their revenues (the price of oil) because over time it will require more and more energy/money to lift the same amount of hydrocarbons out of the ground per year and I don't see this dynamic being continually offset by improved extraction methods/technology.

Another phrase to describe this approach is 'enhanced indexing' - where the indexing is accomplished by first mimicking the sector weights of the overall market and the enhancement is accomplished by removing those sectors that are anticipated to underperform.

I think perhaps next week we might cover why our model portfolio is 'overweighted' to small cap stocks, rather than large caps, and why I favor that portfolio composition. Or perhaps we could cover a metric known as 'beta' and why the average beta of the stocks in our portfolio is purposefully low.