Financial Advisor

Create your own US stock portfolio

Individuals who invest in stocks tend to fall into one of two groups: One group buys specific stocks but has little knowledge of how effectively they capture the performance characteristics of the entire asset class; the second group chooses to manage investments, including mutual funds, index funds, trading Exchange-traded funds or privately managed accounts. The second group may do a better job of capturing the overall performance characteristics of the asset class than the first, although this depends on how well-diversified their total market exposure is.

Is there a way for investors to create a concise portfolio that effectively captures the performance characteristics of the entire asset class of U.S. domestic stocks? This article will show you an easy way to create a portfolio that not only captures this performance, but also allows you to compete endlessly with index funds and actively managed funds.

key takeaways

  • Despite the prevalence of active portfolio managers and low-cost stock index funds and ETFs, many individual investors still want to go out and build their own portfolios.
  • The first thing to do is to set your investment goals and establish a benchmark against which to measure your results.
  • Then you need to develop a rigorous strategy for picking stocks and knowing when to sell or change your view.
  • Research has shown time and time again that individual stock pickers tend to underperform their benchmarks, especially after accounting for taxes and transaction costs.

Build your benchmark

You must have an established benchmark against which to compare to determine whether you are successfully capturing the performance characteristics of the asset class effectively. The benchmark must be comprehensive and recognized as representative of the U.S. stock market.

You can build a large-cap portfolio that mimics the S&P 500. The S&P 500 is made up of large-cap stocks, which account for approximately 80% of the total market capitalization of the U.S. domestic stock market.

The S&P 1,000 combines the S&P MidCap 400® and S&P SmallCap 600® to form an investable benchmark for small-cap stocks in the U.S. equity market. You can build a small-cap and mid-cap portfolio that mimics the S&P 1,000 and capture the rest of the entire asset class.

Standard & Poor’s provides a wealth of free information about its indices that you can use as a guide for building portfolios and comparing performance. You can create a portfolio that mixes the two, with a weighting of about 75%-25%, and captures the performance characteristics of the U.S. domestic stock market, provided you are sufficiently diversified across individual securities and major economic sectors.

Why not buy index funds?

why not? In 1975, Charles Ellis published an article that he later expanded into a book titled win the loser’s game. The main point of Ellis’ work is that most professional fund managers fail to consistently outperform the market because they Yes market. Regardless of asset class, today’s market landscape is dominated by highly skilled, well-trained, and intelligent institutional investment professionals.

John Bogle credits Ellis’ work as one of the main influences of his decision to create an index mutual fund when he started Vanguard Group. Bogle reasoned that index funds were always competitive in the long run — a notion that history has proven correct. You can purchase Vanguard’s Total Market mutual funds with the assurance that you will effectively capture the performance characteristics of the US domestic stock market. Plus, thanks to ultra-low annual fees, sometimes as low as one-tenth of 1% per year, you’ll always feel comfortable competing with almost every other actively managed U.S. equity fund out there.

Why not create your own?

The advantage of creating your own actively managed index fund is that you can potentially alter it to provide slightly higher risk-adjusted returns than the market. Also, in terms of your own personal tax situation, you can usually manage it in a more tax-efficient way than an index fund. In the end, if you enjoy the investing process, you’ll find that managing your own portfolio is more valuable than just owning an index fund.

theory and process

A widely cited study by Lawrence Fisher and James H. Lorie in 1970 showed that with proper diversification, investors could eliminate the vast majority of individual stock risk with as few as 30 stocks. Owning just 30 tech stocks won’t capture the vast majority of the performance characteristics of an index as large as the S&P 500; however, if you choose 30 stocks that represent the entire index, you can capture the vast majority of the index’s performance .

Standard & Poor’s classifies stocks according to 10 broad industry classifications and numerous sub-classifications. It shows the market weight of each sector in the index. You can use this as a guide for proper diversification.

For example, let’s say you will own 30 stocks, each with an initial weight of about 3% of your overall portfolio. If the financials sector makes up 15% of the S&P, you want to own 5 stocks in that sector (about 15% of the 30 stocks). If the energy sector makes up 12% of the index, you want to own four energy stocks, and so on.

Set up a portfolio

Ideally, you don’t want to own more than one stock from any sub-sector in these picks. So, for example, out of your five financial sector holdings, you might want to get one each from the big banks, regional banks, insurance, brokerage and investment management. In effect, you are sampling from an index based on its overall composition and structure.

Not all industry weights are divisible by your 3% average stock weight, so you must carefully decide how many stocks to include in each industry class. Industry category weights change over time, but you’ll find your weights change accordingly. From time to time, you will have to increase or decrease the number of shares (or shares) you hold in each sector, but this won’t happen very often.

Another factor to consider is the weighted average market capitalization. You can calculate the weighted average market capitalization by multiplying the percentage weight of each stock in the portfolio by its market capitalization and dividing by the total number of stocks in the portfolio. You can compare it to the index-weighted average market capitalization published by S&P. You may also want to calculate your weighted average price-to-earnings (P/E) ratio and compare it to the index.

The more you do to ensure that your portfolio mimics the index, the closer your performance will be to the index. In fact, you may want to limit your assets to names that are actually in the index. These names are also available from Standard & Poor’s and include companies that investors see and hear every day of their lives.

pick stocks

If the research is correct, then by following the above process, you can capture over 90% of the index’s performance over time, no matter what individual stock you choose. This process and structure largely protects you from incurring excessive losses due to poor individual stock selections. Nonetheless, this is an area where you can add incremental risk-adjusted values ​​(also known as alpha) over time.

It should be noted that as more stocks are added to your portfolio, further diversification can be achieved, but at the cost of reduced volatility (i.e. the opportunity for greater returns).

eternal competitiveness

You’ll find this approach to be timelessly competitive, not just for market indices, but for virtually any actively managed fund by Wall Street professionals. It is simple, easy to build and cost effective as turnover can be kept to a minimum. However, depending on your personal transaction costs, it may not make sense to create your own US stock market “mutual fund” unless you have about $100,000 to invest, as index funds and ETFs have internal fees averaging only 0.010% to 0.015%. But , if you do have enough money at your disposal, this process will make it easy for you to become your own equity portfolio manager.

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