An increasingly popular strategy is the core and satellite approach to portfolio construction. The bulk of your portfolio, say 80%, is invested in a passive or index tracker funds with the remaining 20% invested in three or four individual stocks.

The aim is to have the combination of the core index and the satellite shares deliver returns greater than if you just had 100% index exposure. While at the same time providing a safety net in that if one of satellite investments crashes and burns it shouldn't drag down your overall performance too drastically.

Naturally, for this strategy to be successful you have to select stocks that will outperform the market – more on that later.

This strategy allows you to invest in the few companies you have strong belief in, while still remaining diversified via the core. The aim is to get some of the benefits of a concentrated portfolio, without taking on as much downside risk. The other key advantage is this core and satellite strategy is a very low cost approach.

Building our solid core

Your core needs to be broadly diversified and very low cost. An ETF like the Vanguard Australian Shares Index ETF (VAS) or the SPDR S&P/ASX 200 (STW) will give you diversified exposure to the broad Australian equity market, all at a low cost.

You can even split the 80% core index into 40% Australian equities and 40% International stocks by adding a broad international focused ETF. The Vanguard All World ex US Share Index (VEU) or the iShares MSCI EAFE (IVE) could fill that role. These ETF's should give a good solid core that will match the index return and provide good diversification while also keeping expenses low.

Getting the Satellites into orbit

As we all know, the top 200 stocks have an army of analysts and fund managers monitoring them continuously. Therefore, it's doubtful your stockbroker will provide any new or remarkable insights that will give you a consistent advantage over others. History tells us it is very hard to outperform the market on a long term basis.

It's also doubtful you will be able to uncover anything that analysts have missed since you won't be doing it as your full time job. However, once we move away from BHP, CBA, TLS and the top 300 stocks the possibility of finding a little gem of a stock that has yet to be uncovered by the market increases.

By finding three or four of these gems, adding them to the portfolio and combining their returns with the return from the core part, we should be able to outperform the market and probably most fund managers!

It is also much easier to understand three or four small companies than the top 300 stocks on the ASX – so we let the ETF's take care of them.

Small Caps can make great satellites

A recent report from S&P showed that 75% of small cap fund manager's outperformed the market. And if the majority of them can do so, then so can we! Researching their top holdings (usually via their website) can provide some good ideas for further research.

Small Caps are also generally easier to understand as they usually have only one product or service as opposed to a big conglomerate like Wesfarmers Ltd. (ASX: WES) which has multiple businesses. Remember the golden rule of investing is not to invest in anything you don't fully understand.

I tend to look for stocks that are already paying regular fully franked dividends as it is an indication that the business is through the hard start up phase, profitable and most likely to have a good operating cash flow.

A good return on equity figure is also a good indicator that the business is continuing to grow. Companies like Reckon Ltd. (ASX: RKN) and Corporate Travel Management (ASX: CTD) fit the bill here. Both have strong business models and while not micro cap stocks they are still small enough to be off the radar of most of the big players.

If you are looking satellite stocks you can bet on now, readers need look no further than The Motley Fool's Top Stock For 2012. Click here now to request this special report, while it's still free and available.

Fool contributor Mark Tobin does not own any of the shares mentioned in the above article. Mark works for Wilson Asset Management, and that firm or its clients may own any of the shares mentioned above. These positions can change at any time. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

The post Remain diversified while concentrating on your top stock ideas appeared first on The Motley Fool Australia.

More reading

• I screened the ASX 200 for shares that could outperform over the next 5 years. This is what I found
• Could just 2 ASX ETFs be enough to build serious wealth?
• Top brokers name 3 ASX shares to buy next week
• I think these 3 ASX 200 shares could outperform the market in 2027
• CBA vs Wesfarmers: Which looks best for a 50-year-old investor in 2026?

This pullback does make some stocks appear compelling from a dividend yield viewpoint. The major banks, National Australia Bank (ASX: NAB), Commonwealth Bank (ASX: CBA), Westpac (ASX: WBC) and ANZ (ASX: ANZ) are now all yielding around 6%. Take into account the fully franked nature of their dividends and they have even more attractive yields.

But investors shouldn't just chase yield for the sake of it. The banks have some question marks over them. The cooling housing market and sluggish to falling credit growth raises some concerns about their ability to fund future dividends. That said, people with an investing horizon that can be counted in years rather than days, may see through the short-term economic woes and see today's dividend yields as being tempting.

Yield on Cost

While the banks are yielding quite well right now, they may not have the future growth prospects of other companies. You may be better searching for companies with good dividend growth rates that will hopefully become high yield shares over time, based on your initial cost.

Austin Engineering (ASX: ANG) and Ansell (ASX: ANN) are two that might fit the bill. Austin has a 3 year dividend growth rate of over 30% while Ansell's 8% growth rate is nothing to sneeze at. Who would decline an 8% pay rise?

Neither company is trading on a particularly high dividend yield today, but the goal here is to have your yield-on-cost rise each year as the dividends grow, creating some high yielding shares in your portfolio over time.

Diversification from the Australian Dollar

Getting dividends from Aussie shares is a nice little earner. However, with the Australian dollar riding high compared to its historical norms, this could provide an excellent opportunity to acquire some international blue chips.

There is no denying though that an opportunity to acquire global titans like Johnson & Johnson, 3M and IBM is one worth considering.

3M was trading around $US120 in early June 2001 with the AUD/USD rate around 50c, so the total cost in local currency was $A240 per 3M share. Fast forward to now and 3M is trading around $US95 and the AUD/USD rate is $1.07, so the local currency cost per 3M share is just $A89 per 3M share. Needless to say that is a big difference from the $A240 cost of a decade ago.

Pay cheque from abroad anybody?

The aforementioned blue chips also pay regular dividends. If the strong Aussies dollar loses steam then you'll see a juicer dividend cheque come through the door. A fall in the forex rate may also lead to a possible or even amplified capital gain when you decide to sell these international shares.

This strategy does force you to take a view on the forex rate and adds currency risk to your portfolio. The diversification benefits, however, shouldn't be overlooked. Having U.S. or any international shares adds currency, geographical and sector diversification to your portfolio. This diversification is especially valuable given the resource and material sector dominance of the Aussie share market.

The current opportunity to acquire international blue chip stocks at these favourable exchange rates is worth considering and with the financial year just ended, perhaps it's adding a New (Financial) Year's Resolution to your list?

Fool contributor Mark Tobin does not own any of the shares mentioned in the above article. Mark works for Wilson Asset Management, and that firm or its clients may own any of the shares mentioned above. These positions can change at any time. The Motley Fool has a fine disclosure policy.

The post Profit From The Strong Aussie Dollar appeared first on The Motley Fool Australia.

More reading

• I screened the ASX 200 for shares that could outperform over the next 5 years. This is what I found
• Could just 2 ASX ETFs be enough to build serious wealth?
• Top brokers name 3 ASX shares to buy next week
• I think these 3 ASX 200 shares could outperform the market in 2027
• CBA vs Wesfarmers: Which looks best for a 50-year-old investor in 2026?