Asset Allocation (Part II)

When financial journalist and author, Ric Edelman, does his thing on PBS, one of the more interesting parts of his presentation is a demonstration of the importance of sector diversification. He lists different sectors of the economy (not everyone agrees on how to categorize the market), then he places a different colored block next to that sector representing how “hot” that sector was in the previous year. Then he shows the same information for the last 10 or more years. The result is a meaningless blob of seemingly random color patterns. The point is what is hot this year will not be hot every year. There is not even any meaningful pattern that a sector will follow over a number of years. The actions of market sectors over time are impossible to predict. Therefore it is wise to diversify across all sectors of the economy.

Remember, as you read these numbers, they apply only to common stocks. This information assumes that, depending on your age, tolerance for risk, and financial situation some percentage of your investments are in bonds, cash, and certificates of deposit.

The two page fact sheet for the C fund from my TSP retirement account indicates that the S&P 500 Index breaks down into the following industry groups.

11.2% Energy
15.4% Financials
13.4% Health Care
19.0% Information Technology
3.1% Telecom Services
3.4% Materials
3.8% Utilities
9.0% Consumer Discretionary
9.9% Industrials
11.7% Consumer Staples

Index funds, such as the C fund track the S&P 500, rebalancing from time to time in order to reflect changes in the importance of different sectors of the economy. Many people consider (LOW COST!!) index funds such as those offered by Vanguard as a nearly ideal method for the small investor to share in the profits of large companies. I am looking at a graph of the Dow Jones Industrial Average (an index that is similar to and closely tracks the broader S&P) from 1945 until the present. Although there are some nasty humps and bumps along the way, the line is remarkable close to linear as starts at 150 and ends at 10,900 over the last 65 years. Warren Buffett, the genius, famously bet a manager of a hedge fund a total (at maturity) of $1,000,000 (the proceeds go the charity of the winner’s choice) that a low cost S&P Index fund will beat any hedge fund selected in advance over the next ten years. We shall see.

Now, let me admit my prejudices. I like stocks that pay a dividend. I tend to be suspicious of any company that does not want to share its profits with its owners. Of course high tech startups need to plow profits back into research and development, but when is enough, enough? Cisco Systems and Apple are sitting on multi-billion dollar war chests. They are world recognized, well established brands. It is time they share their wealth with someone other than corporate managers with stock options. Almost all of my individual stocks pay a dividend. Some of them pay a very good dividend. I tend to believe in companies that produce stuff that people have to buy or are going to buy anyway. Therefore I am overweight (compared to the S&P 500) in areas like energy, consumer staples, and regulated utilities. Somehow I believe that no matter how the economy is faring, people are going to buy gasoline and toilet paper.

The stock funds in my retirement account are index funds. Sharing the distribution of my personally directed money, as categorized by Schwab, would require more effort than I am willing to undertake. For example, Schwab shows that I have 0% in basic materials. They categorize GoldCorp, a Canadian mining corporation, as a foreign stock and they helpfully categorize Plum Creek Timber, a wood products and land development Real Estate Investment Trust (REIT), as “other.” Both those companies meet the definition of materials.

Argus, a financial research company suggests a number of model portfolios showing sector diversification. They also suggest individual stocks to hold within these portfolios, but I will let you look up that information.

Equity Income

6.3% Basic Materials
12.6% Consumer Discretionary
3.4% Consumer Staples
11.6% Energy
9.0% Financial Services
8.7% Health Care
8.7% Industrials
6.0% Technology
6.8% Telecom
26.8%Utilities

Growth and Income

3.2% Basic Materials
7.8% Consumer Discretionary
9.1% Consumer Staples
14.3% Energy
18.2% Financial Services
8.0% Health Care
7.8% Industrials
15.9% Technology
2.1% Telecom
13.4% Utilities

Mid-Cap Growth

0.0% Basic Materials
12.0% Consumer Discretionary
3.0% Consumer Staples
11.4% Energy
8.2% Financial Services
25.8% Health Care
11.4% Industrials
24.3% Technology
0.0% Telecom
3.9% Utilities

Before starting to build a portfolio of stocks and/or common stock funds, develop a plan to achieve a goal. This plan, of course, will be modified over time as your financial position, risk tolerance, and age change. Right now I seem to fall somewhere between the Equity Income and the Growth and Income models. Since Schwab classifies stocks as small cap or large cap, I can only guess at what I might own that Argus would classify as mid-cap. Don’t allow your decisions to be ruled by your emotions. If you do, you will sell when the market is at or near a bottom and buy just before it reaches a peak. These are two of the most common mistakes made by individual investors.

Finally, know what stocks are in your funds. You may not be as diversified as you think. For example, here are the top ten holdings of the C Fund as of December 31, 2009. A star before the company name indicates that I hold the stock in my self directed account.

Exxon Mobil
Microsoft
Apple
* Johnson & Johnson
* Proctor & Gamble
IBM
* AT&T
JP Morgan Chase
* General Electric
* Chevron Texaco

And, Hey! Let’s be careful out there.