Investors should build their portfolio based on their goals, outlook and financial position, not according to someone else’s rules. By building a portfolio based on another investor’s strategy or outlook, one is setting themselves up for failure. Just because Warren Buffett (Trades, Portfolio) has an equity portfolio that is heavily concentrated in four key positions, it does not mean everyone should follow the same course of action. Buffett has been investing for decades and knows how to build a portfolio he is comfortable with -- the same can be said for many other famous investors.
Build your portfolio
For the most part, the equity portfolios of billionaires and hedge fund managers are unsuitable for the average investor. Yes, these portfolios can be helpful in finding investment ideas, but ultimately, your portfolio should be based on your own investment outlook and should consider the amount of time you have to develop your own strategy. If you cannot invest full time, it might be best to buy a simple index tracker or hire someone else to manage your money.
Introducing the core
Personally, I have a full-time job. As much as I would like to manage my portfolio, there is just no way I would be up to fit it alongside everything else. That being said, I do not want to have to pay someone to manage my portfolio for me, and when I get the time, I like to do my own research. With this being the case, my portfolio is built around a core and satellite structure, a layout I believe all investors who want to manage their own investments should adopt.
It is well known that the average investor underperforms the S&P 500 over the long term. According to Dalbar’s annual Quantitative Analysis of Investor Behavior study, over the 30 years to year-end 2015, the S&P 500 returned an average of 10.35%. The average mutual fund investor only achieved a return of 3.66%. You may look at these figures and say it is the active funds that are holding back investors, but Dalbar found it is actually investor behavior that is the number one cause of poor returns.
This analysis supports the argument for core and satellite approach. In the core of the portfolio, I believe an equity index fund or style fund such as value is the best holding. An investment of this type would provide exposure to a well-diversified basket of securities for minimal cost.
Once this core is in place, you can build out the rest of the satellite portfolio. This satellite portfolio is where I include my own ideas. Because the core of the portfolio is in place, there is no pressure on me to look to outperform the market with my other holdings. I can take a long-term view knowing the middle of the portfolio will generate steady returns that match the wider market, while in the rest of the portfolio I can own more speculative or contrarian positions that may not pay off immediately.
Additionally, if I mess up by making a poor investment choice, I will not lose all of my wealth since the core portfolio is invested in the S&P 500.
The bottom line
All in all, I believe the best way to build a portfolio is around a core holding of an S&P 500 or style index fund. With a core holding in place, you can experiment with the rest of your portfolio. If it turns out you are rubbish at investing, you will not lose your retirement fund with no hope of making a comeback.
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