How I plan to Optimize Sector Allocation – Part 1

Introduction

If you have been following me on this blog then you will know that I invest capital every month.  I take €1250 from my paycheck each month looking to buy a couple of stocks to keep my fees low.

When choosing stocks I have a set of rules or metrics which help me narrow down my watchlist. This usually amounts to about 5 companies a month. This appeared to be working fine until The Sunday Investor used Performance Attribution to compare my portfolio against a benchmark of ETFs.

Rules, rules,rules

Buying stocks based on a set of rules has advantages but are you maximizing your returns? Would your dollars earn more in a set and forget ETF strategy for example?  Are you missing out on better alternatives because they miss one out on one criterion?

It is important to note down your goals as an Investor. Are you investing for cash flow? how about investing for capital gains?

Are you investing for both? If not than why not?

 Having clear goals will help tailor a portfolio to your own needs. By checking the performance periodically you can see if you are on the right path.

Performance Attribution

Performance attribution can be used to evaluate a portfolio’s return vs an appropriate benchmark. In my case it is being used to determine how my asset allocation (sector) and company allocation affect my portfolio in comparison to the benchmark.

Total Attribution

The active return in the table above is the difference between my portfolio and the return of the benchmark. It is calculated by adding the Allocation Effect and Selection Effect together. Using my portfolio from Jan 1^st my total return was 0.85% or 85 basis points above the benchmark.  

Allocation Effect

The allocation effect determines if the weightings on your sectors have a positive or negative impact on your portfolio. This is calculated using the following formula:

 (Portfolio weight  – Benchmark Weight) * Benchmark Return.

In an ideal situation, we are looking to be overweight in sectors that are outperforming the benchmark. And underweight in sectors that have underperformed the benchmark. Conversely, we don’t want a situation where we are overweight in a sector that is underperforming the benchmark and underweight in a sector that is outperforming a sector.

In my portfolio you can see that I have a negative allocation for Communication Services and Real Estate.

Selection Effect

The selection effect evaluates the portion of the performance from picking individual stocks. It predicts what the return of your portfolio would be if the weights of the individual sector were identical in your benchmark and portfolio. This is calculated using the following formula:

 Portfolio weight  *(Portfolio Return – Benchmark Return)

When selecting your benchmark, I should note that this does not have to be against ETFs. You could for example select the top 2 stocks in each sector by market cap. Which interestingly enough would of beat my portfolio by nearly 300 basis points.

At a quick glance beating my benchmark by 85 basis points seems like a good result. But if you look a little deeper you might notice I have a small problem.

Those will an eagle eye will have spotted that my allocation effect is negative 0.87%.  What does this actually mean?

This means I am not optimizing my weightings correctly across each sector.  I am overweight in areas such as real estate and communication services but underweight other areas such as IT. In short I could be earning more if my allocations were weighted a little differently.

Risks of ignoring allocation

This risk of over-relying on one sector seems a little obvious. Been overexposed may look great in a bull run. But you run the risk of suffering from Recency Bias without considering that you may have purchased during the sector peak.  The most obvious recent examples for this would be the tech bubble and the financial crisis. Both sectors blew up within the last couple of decades and if you were overweighted in either of these during this time it would have hurt your portfolio badly.

No one has a crystal ball of course and past performance does not predict future results but if the past has taught us anything it is that correctly diversifying your investments across asset classes is important but even within each asset class a diversified portfolio might stand you in good stead.

Why not ETF’s

it would certainly be easier to buy 5 or 6 ETFs and spread out your allocation with minimum effort. It would certainly save me some time. But it would also give me nothing to write about. I could lie and say that I chose to pick individual stocks to have more control.

This would not be true, in fact I believe that for new investors not having huge amounts of control can be a good thing. As you learn and gain confidence, stock picking might become a better option. But for the majority of investors ETFs would be a perfect fit.

I personally feel like I was pushed down this road due to Ireland’s unfair treatment of ETFs. I have touched on it here, where I discussed the high tax rate, deemed disposal, and the inability to offset losses. But that does not mean ETFs cannot form part of an overall investment strategy. It just means that it will not be the main focus of an investment strategy for me.

Next series

I deliberately kept this post quite short and will break this topic up into a number of posts over the coming weeks. I don’t want to bore you or throw to much information at you at once. In the next part of this series I will look at becoming more familiar with each of the 11 sectors. We will also briefly look at some of the industries within each sector.

This should lead nicely to describing what my new allocation targets will be and why. I also hope to outline my roadmap to achieve this allocation over the next few months.

By the way for anyone looking for a copy of the spreadsheet I used above, I suggest you check out this post.

If you have any questions or queries please let me know and I will do my best to help in any way that I can.

As always, Thank you for reading and Happy Investing!

Disclaimer - Engineer my Freedom is not a licensed or registered investment adviser or broker/dealer. We are not providing you with individual investment advice on this site. Please consult with a licensed investment professional before you invest your money. This site is for entertainment, informational, and educational use only. Any opinion expressed on the site here and elsewhere on the internet is not a form of investment advice provided to you. We use information, data, and sources in the articles we believe to be correct at the time of writing them, but there is no guarantee of their accuracy, completeness, timeliness, or correctness. We are not liable for any losses suffered by any party because of information published on this site or elsewhere on the internet. Past performance is not a guarantee of future performance. By reading this site or subscribing to it, you agree that you are solely responsible for making investment decisions in connection with your funds.