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This article appeared in the August 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Two books that explain how top investors build portfolios.

Photo of Sean Dostal By Sean Dostal, Moneybags

There are many schools of thought on how to best manage your portfolio for the best reward at an appropriate level of risk. Fund managers usually approach this in one of three ways: active portfolio management, index investing and focus investing (Buffett style) funds.

The differences are explored in depth in The Warren Buffett Portfolio by Robert Hagstrom and The Gone Fishin' Portfolio by Alexander Green. [All books mentioned are available at Moneybags for 20 per cent off RRP in August 2011.]

Hagstrom neatly compares the three approaches:

  • Active portfolio managers constantly buy and sell a great number of shares. They try to predict what will happen in the market in the next six months and constantly churn their portfolio, hoping to take advantage of their predictions. These funds generally hold more than 100 companies and have portfolio turnover ratios of 80 per cent.
  • Index investing is a buy-and-hold passive approach. It involves assembling and then holding a broadly diversified portfolio deliberately designed to mimic the behavior of a specific benchmark index, such as the ASX 200.
  • Focus investing is the approach that Warren Buffett uses: choose a few shares that are likely to produce above-average returns over the long haul, concentrate the bulk of your investments in them, and have the fortitude to hold steady during any short-term market gyrations. Buffett says the ideal portfolio should contain no more than 10 companies.

Assessing which approach is best

Both Hagstrom and Green talk about the pitfalls of active portfolio managers. Active managers argue that by virtue of their share-picking skills, they can do better than any index. However, both books cite statistics showing a vast percentage of active fund managers have underperformed the benchmark S&P 500 index over time.

Hagstrom cites the inherent difficulties of short-term predictions and high trading costs as two main factors. Green also talks about the fees charged by advisers (financial planners, brokers etc) and how over time they can greatly affect compounded returns.

Interestingly, Buffett famously said: "By periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals." He believes that a disciplined individual has a significantly better chance of beating the index by adopting focus investing, which is based on the following approach:

  1. Find outstanding companies
    Buffett devotes most of his attention to analysing the economics of the underlying business and assessing its management, not to tracking the share price. Check each opportunity against a set of investment tenets/fundamental principles. Companies should have a long history of superior performance and a stable management. Some detail is provided on this, but for the full method, read the prequel, The Warren Buffett Way.
  2. Less is more
    Own five to 10 companies. If you are an experienced investor, able to understand business economics and to find five to 10 companies that have important long-term competitive advantages, conventional diversification makes no sense.
  3. Put big bets on high probability events
    When you encounter a strong opportunity, the only reasonable course of action is to make a large investment.
  4. Be patient
    Patiently hold your portfolio even when it appears the other strategies are marching ahead. As the investment holding time lengthens, the economics of the underlying business will increasingly be reflected in its share price. Buffett's suggested portfolio turnover is 10 to 20 per cent.
  5. Don't panic on price changes
    Focus investors
    tolerate price volatility because they know that in the long run the underlying economics of the companies will more than compensate for any short-term price fluctuations.

Green, on the other hand, advocates index investing but has allocated funds among a mixture of asset classes. He argues that the most important investment decision is selecting the mix of assets to be held in the portfolio, not selecting the individual investments. The Gone Fishin' Portfolio is designed to eliminate six major risks:

  1. It keeps you from being too conservative
  2. It prevents you from handling your money recklessly
  3. Does not require you to own any individual shares or bonds
  4. Does not require a broker or financial consultant
  5. Does not require you to forecast the economy or predict the market
  6. Guarantees that you will not spend all your time managing your investments.

It consists of a weighted mix of 10 asset classes, including shares, bonds and real estate investment trusts. It includes riskier assets (gold shares, emerging-market shares, high-yield bonds) to keep returns higher and portfolio risk lower. There is also a combination of non-correlated assets to smooth returns over time. It can be executed through low-cost index funds or exchange traded funds (ETFs).

A key component is that once each year you rebalance the portfolio to the original weightings (by making additional investments or selling some shares). This gives a clear discipline of when to buy and sell, and forces you to buy low and sell high.

Both books explore these issues rigorously and put forward a good case for each approach. Also covered are more in-depth discussions on the pros and cons of diversification and asset allocation. The books challenge conventional thinking and have interesting insights that you will not read in the financial press. They are also great value at under $30 each, including shipping within Australia.

About the author

Sean Dostal is the managing director of Moneybags.com.au, a leading online shop for investment books, software, courses and newsletters. For more information (including chapter extracts and author profiles) or to purchase books mentioned in this article, visit Moneybags.

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