What football can teach about the art of portfolio construction

So I'm sitting down to watch the first match of the Brazilian world cup and I realise that my 7 year old son knows the name of every single player on the pitch. Not only that but he knows their positions and their shirt numbers too. Now I'm not totally ignorant on football matters, but his depth and understanding of the game astounded me. I've kicked plenty of footballs in the garden, but I couldn't remember force feeding his memory with this information. I could only presume he'd taken it all in by osmosis...

Children have always been bathed in team sport culture, from the playground and games fields of yore, to the video games, apps and TV of today. If you ask anyone to construct a football team, even if they don't know any players, they'll likely understand the rudiments of attack and defense - it's in their very fibre. You'd need a goalkeeper, defenders, midfielders, and strikers... 4-4-2... a balance between safety at the back, playmakers in the middle and firebrand talent at the front. It might be hard to make a unit gel, but there's barely anyone who'd stick a striker in goal.

From footie to folios...

Given our grounding in team sports, I often wonder why investors seem to have so little clue about portfolio construction & diversification. A standout research paper by Kumar and Goetzmann in the 1990s studied the diversification and investment results of 60,000 individual investor accounts at a retail brokerage. Astonishingly they found an average holding of about 4 stocks per portfolio, mostly all held in the same sector. That's the investing equivalent of starting a football match with just a handful of strikers and hoping to get lucky.

Football teams and portfolios really aren't all that dissimilar, but the way the game is played is. Rather than charging at you head on, the market lulls you into a false sense of security, teasing you into feeling comfortable playing with just a handful of players... letting you strike a few goals, letting you take and defend a lead... only to snap back and counter attack months or years later, right at the moment you've grown most complacent.

It's the slow tempo of the stock market game that encourages too much risk taking and a poor selection of players. Structuring your portfolio to protect against delayed consequences is mission critical in stock markets, and it starts with giving every stock a role....

Give every stock a role...

Both risk seeking and risk aversion play a part in our financial lives. We buy lottery tickets for the upside as well as insurance on our assets for the downside. While many novices treat their stock portfolios as a lottery tickets, they usually don't last long. By segmenting your portfolio into different 'mental accounts' you can allocate more clearly to managing downside risks without restricting upside... from defenders (conservative stalwarts) through midfielders (midcap quality and growth) to strikers (aggressive smallcap speculations or moonshots).

"Pah, who wants to own conservative FTSE 350 stocks!" small cap speculators cry... 'elephants don't gallop'. But markets are cyclical, small caps come in and out of fashion, and when they fall, as we've seen recently, they fall hard. An aversion to owning any defensive stocks at all can be fatal. Unlike footballers though, stocks don't come with labels like defender or attacker... so often we've no idea how a new player fits into our team. We need a metric to measure the idea of risk or 'defensiveness'.

While many disdain the use of share price volatility as a measure of risk, there is no doubt that it has its worth. In recent years academics have found that low volatility stocks actually outperform high volatility stocks on a risk adjusted basis. Conventional investment thinking says you need to take higher risks to get higher returns... but this 'low volatility anomaly' turns it on it's head.... boring stocks beat exciting stocks.

While low volatility stocks tend to underperform in market upswings, they outperform in market downswings as they don't fall as far or as fast. As such, low volatility stocks can act as a defensive wall, helping to buffer drawdowns and smooth the emotional ride. Contrary to the age old sporting maxim that the key to a good defence is a good offence, in investing the secret may be that it's the other way round... indeed Warren Buffett built his fortune in precisely these kind of shares.

Composing the right team...

On the subject of broader team selection we can push the football analogy further. Good managers will always field players of various ages and experience (different industries & stages of business cycles) with plenty of foreign talent (geographic sales exposure) and won't forget to field a team with the full quota of players (breadth).

Thinking like this can help you structure a well balanced portfolio that covers the key diversification themes across risk, industry, geography and breadth... with plenty of stocks that zig when others zag. Footballers are rarely schooled in the arts of public speaking but they will happily trot out such cliched observations as 'we really gelled as a unit tonight' or 'what we lack in stars we made up for in team spirit'. These observations are an admittance that in any team there's another power at work - that if the players can complement each other they can become stronger than teams of far greater individual ability.

The trouble with software...

Kumar and Goetzmann's rather sad study concluded that "investors realize the benefits of diversification but face a daunting task of implementing and maintaining a well diversified portfolio". And it's certainly true that most investment software does a terrible job of making these things easy.

Much of the work we are doing behind the scenes here at Stockopedia I am hoping will address these issues. The goal being to understand how new stock selections fit into your portfolio as a whole, not just as standalone speculations. A question like... "Should you really be buying that new expensive striker when you've a glaring hole at the back?" is the kind of question that good software should be raising before you make a new purchase. In the meantime, I've read somewhere that a good metaphor acts as a bridge from the known to the unknown, and while I'm not sure that good football managers make good stock pickers I do hope this article sparks a few portfolio reviews.