On portfolio construction

I’m building a portfolio with the goal of achieving market-beating returns over the next 5 years. This raises an important question:

Should I invest all the money up front, spread it out evenly over the 5 year period, or some other strategy?

Some very skilled fund managers that I follow invest their cash quite quickly when they open a new fund, becoming almost fully invested (excluding the specified amount of the portfolio they keep in cash) within 6mths to 12 mths. I’m certainly not going to second guess that decision, as their records speak for themselves.

Yet to my way of thinking, investing 100% of the portfolio up front (minus whatever is kept in cash) raises the spectre of poor timing or getting the pricing decision wrong. I don’t believe in market timing per se, but if you invest all of your money at one time and never add another cent, there is a reasonable chance of underperforming over a 3-5 year time frame due to unforeseen circumstances, a market crash, whatever.

This is a concern twice over because if you’re fully invested too soon, you can’t add cash to companies where the story strengthens, and you take all of the hit at companies where the story weakens. I think it would be safe to say that investing 100% of the portfolio right now, or in the first year, is not the correct solution.

Also, you can only buy as many stocks as you have good ideas, and I already own my only two good ideas. It will take me some time to do some due diligence and generate a few more possibilities.

What if I break up the purchases evenly, say 20% of the portfolio per year? 

On the face of it, this seems reasonable. However the downside is that, for every year that goes past, I have one fewer year for those stocks to perform. For example, stocks that I buy in Year 3 only have ~2 years to show their worth before the end date of the experiment. Assuming I invest in even increments over time, 50% of the portfolio would have only 2.5 years to strut its stuff. That’s not long enough.

If I was holding for 20 years, that would not be an issue – and actually, I do hope to hold some of these stocks for the long term. But the goal of my experiment is specifically to show market beating returns by the 5 year mark, which places some interesting constraints on my investment strategy.

So I want as much time as possible, without putting too many eggs in baskets too soon?

I think a neat solution would be to weight the investment to the first half, something like this:

With 40% of the investment in the first year and 30% in the second, that gives 70% of the portfolio 3-4 years to perform. I have allocated 15% of the portfolio to the 3rd year, for a total of 85% with a theoretical cash holding of 15%.  Year 4 and Year 5 investments simply reflect if there is some cash recycled from earlier investments that might get sold, or if I decide to completely invest the portfolio in stocks, with no cash.

Likely the final 3 years’ figures will be significantly different when I get to that point.

Why 40%? 

No particular reason, other than that 20% was too low.  Having chosen that figure, I also don’t want to be constrained to my own detriment by artificial rules. Choosing not to invest in an attractive opportunity just so I can keep my first year investment to the artificial limit of 40% of the portfolio would be lunacy. However, I think I could also safely say that if I got to the end of my first year and had 70% invested, that’s too much.  So the process involves balance all around. Probably the first year will see me somewhere between 30% and 50% invested, and I would be comfortable with that.

What about cash?

There is a very good argument for keeping cash around, especially if we’re heading into tougher economic times as I suspect. However, the counter-argument says that, for an experiment designed to show my ability to pick stocks, what’s the point of holding cash? I might as well try to make as many good picks as possible. I will tackle that dilemma, and also the question of how much cash to hold, at a later date.

The bottom line

I think it is a prudent strategy to weight my investment towards the front half of my chosen time frame of 5 years, while still keeping some cash in reserve for other opportunities that I know will crop up. I expect to invest somewhere between 30% to 50% of the portfolio in the first 12 months, and another 20% to 30% in the second year.

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