Diversification is Key

When investing in capital markets, two basic types of risk exist: systematic and unsystematic risk. The risk that any one individual publicly traded company can fail and its stock become worthless is unsystematic risk. The risk that broad markets worldwide can rise and fall dramatically and often simultaneously due to changes in economic growth, central bank policies, interest rates, wars, and other factors is systematic risk.

Broad diversification is the solution to reducing if not eliminating unsystematic risk and is a fundamental investment principal by which we strictly abide. Systemic or “market” risk cannot be diversified away, but it can be managed by investing in non-correlated asset as explained above.

Therefore, Exchange Traded Funds (ETFs) are the building blocks of our portfolio structure. They are our preferred investment vehicle to gain broad asset class or industry group exposure. Most ETFs are like mutual funds in that they are a broadly diversified fund but are traded on exchanges like stocks. The ETFs we use are internally passively managed and designed to track the performance of a particular index and, thus, have very low internal trading costs and management expenses.

The most significant advantage ETFs have over traditional open-end mutual funds is they are typically more tax-efficient. A mutual fund is constantly issuing and redeeming shares to investors. The fund manager must often sell securities in the portfolio to meet redemptions, and this causes tax consequences for remaining shareholders. ETFs have a fixed number of shares, and a liquidating investor sells her shares to another investor on an exchange. Any capital gains are born only by that investor, not the remaining ETF shareholders.  Since most ETFs—and all the ETFs we use—are designed to passively track indexes, turnover within the ETF is very low and, thus, taxable distribution from ETFs are minimal.

Most of all, we like ETFs because the ones we use have liquid options markets.

Individual stocks

For larger portfolios, we include some well researched individual stock selections in an attempt to enhance our asset class returns. We believe the most appropriate way to select individual publicly traded stocks should be the same as one would use when buying a private company,i.e. by using an appropriate business valuation model. Thus, we purchase shares of companies that trade at discounts to style-appropriate, longer term discounted cash flow models.

We also favor companies that have strong balance sheets, high profitability, and low capital requirements. For diversification, we cap portfolio allocations at purchase to no more than 5 percent of the total portfolio. However, the typical allocation at purchase is 1.5 to 3 percent.