One of the most challenging things for new investors used to be deciding what stocks to add to an investment portfolio but it’s much easier to construct a stock portfolio these days – and it will cost you less than you might think.
I am assuming that you would already have developed an investment plan that defines your investment objectives and the market benchmark that you are looking to beat.
Most long-term investors looking to invest for an early retirement will probably be trying to use a “core-satellite” investment strategy to achieve their goals.
What is core-satellite investing?
The “core” component is made up of a passive asset (e.g. stock and/or bond index funds) that mimics the performance of your investment benchmark. Most of your investment capital is typically allocated to the core.
The “satellite” component is made up of investments that you will actively manage to help you outperform your investment benchmark (this will become clearer in the example below).
The advantages of a core-satellite investment portfolio are that it tends to be reasonably low-cost to maintain, requires modest initial capital and is relatively low-risk (although that depends on what asset or assets are held in the core).
What’s more, you can build a core-satellite share portfolio in three easy steps and I will use an investor looking to generate returns that are similar or better than the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index as an example.
- Selecting core assets
Buying an exchange traded fund (ETF) that mimics the ASX 200 is probably the most cost-effective way to building the core. An ETF can be bought and sold on the ASX just like any stock and is usually liquid enough to cater to most retail portfolios.
Anyone who has invested in microcap stocks understands the challenge of liquidity when there aren’t enough buyers and sellers to accommodate a large order. The vast majority of retail investors shouldn’t have any issue getting their orders fulfilled when buying or selling an ETF.
You can also buy a passive index fund. Such investments have been around for longer than ETFs but they usually attract higher fees, although competition from ETFs have put downward pressure on these funds.
You should shop around for the best deal.
- Launching satellites
This is the part of your portfolio that should be outperforming the core. For instance, if you thought that mining stocks will perform better than most other sectors, you can buy shares in BHP Group Ltd (ASX: BHP) and Rio Tinto Limited (ASX: RIO).
The more adventurous investor can also short-sell stocks that they thought would underperform. Short-selling is borrowing shares you do not own to sell on-market in the hope of buying it back at a lower price later to profit from the difference.
Though this process, you can go overweight or underweight on categories of shares to reflect your investment views.
Building your satellites is more demanding than picking your core assets, but it’s also the most fulfilling in my view.
What’s more, if you are bearish on equities on the whole, you can allocate all your capital for your satellites to cash.
You can also leave the hard work to others by investing in an active fund manager and how much of your capital you set aside for the satellites will typically reflect your risk appetite and your confidence as a stock picker (or confidence in the active fund manager).
- Tracking your core-satellite
Using the core-satellite strategy will require you to regularly monitor the performance of your portfolio, particularly if you are picking the satellites yourself as this part of your investments will determine how well or badly you perform versus the benchmark.
Market conditions are dynamic and you shouldn’t be afraid of jettisoning your satellites as market fundamentals shift.
In my experience, it really helps to read widely on the market to understand the headwinds and tailwinds impacting on the various sectors and this is where sites like the Motley Fool can be useful.
Finally, the core-satellite strategy can be modified to suit a wide range of benchmarks like international equities or bonds as there are ETFs that track a wide range of asset classes.
Just be aware that not all ETFs (or passive index funds) are created equal. Some ETFs are better at tracking a benchmark than others.
Also, be conscious that you might be going more overweight on a sector than you intend. This is particularly the case for sectors that make up the bulk of a share index, such as the big banks. Adding bank stocks to your satellite can really hurt if this sector underperforms.
Motley Fool contributor Brendon Lau owns shares of BHP Billiton Limited, Commonwealth Bank of Australia, Rio Tinto Ltd., and Westpac Banking. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.